Doubts of Dollar Dominance are Taboo, but Gold’s Message is Glaring (August 26, 2024)

Americans’ diminishing purchasing power warrants consideration of alternative currencies

Jerome Powell revealed more in Jackson Hole than the Federal Reserve’s intention to begin cutting interest rates next month. His callous comments about inflation showed a lack of appreciation for the damage the central bank has done to the U.S. dollar and American prosperity. Investors might heed his remarks as a warning, if an unwitting one.

Discussions of declining dollar dominance have long been relegated to the fringes of economics and finance, treated as a form of doomerism that is as unrealistic as it is taboo. But reality is changing fast, and denial, as policy makers disrespect the dollar, will only exacerbate the consequences of any potential regime change.

“The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board," Powell joked Friday. Laughs were audible as he went on to say that in the audience he recognized fellow “shipmates.”

Inflation continues to cool, but it is still above the Fed’s stated 2% annual target. What is more, prices as measured by the consumer price index are up 22% since April 2020. That is another way of saying that Americans have lost more than a fifth of their purchasing power in about four years.

Gold tells an even more damning story of the dollar’s purchasing power. The metal’s march over $2,500 hasn’t happened in a vacuum. Nor has it been a coincidence. As commentator James Rickards puts it, gold’s ascent “tells you little about gold and everything about the dollar. Gold is the ocean, the real measure of things.”

Depending on the ear, Rickards comments sound poetic or dramatic. Either way, the point is crucial. Even when inflation is moving in line with the Fed’s target, monetary policy is set to devalue the dollar by 2% a year. Since April 2020–the same window during which the CPI rose 22%--gold has risen 49%, highlighting the damage already done to the dollar.

If interest-rate differentials normally drive the dollar, it is no surprise that imminent Fed rate cuts are weighing on the currency. The decline has been broad and not just against the euro- and yen-heavy DXY, an index measuring the value of the dollar against a basket of six major currencies. Peter Boockvar of Bleakley Financial Group notes that the Indonesian rupiah and the Thai baht are at the highest since early January, the Korean won is at the highest since March, and the Singapore dollar is at the highest since January 2023.

But there is more afoot. Consider a recent report from Citigroup saying that hedge funds are swapping the dollar for the yen to fund carry trades, where investors borrow in a low-interest-rate currency and invest the proceeds in higher-yielding assets elsewhere. It is true that the Bank of Japan has lifted rates off the floor at a time when the Fed is about to cut rates, and it is unclear how much of a dollar carry trade is actually happening. But the fact that Citi is observing it at all suggests there is more at play than expectations for a somewhat smaller gap between U.S. and Japanese rates.

Boockvar asks rhetorically at what point will the dollar reflect worries about U.S. debt and deficits more than expectations about Fed policy. Gold may suggest we are nearing that point.

Unlike past periods of credit-driven inflation, the inflation of our time is because of monetary debasement that shows no sign of abating, says Dan Oliver of Myrmikan Capital. The U.S. debt-to-GDP ratio is now 122%, well above levels that get countries into distress. He adds that this level of debt was matched in 1946, but that was at the end of war spending; the debt fell to 32% of GDP by 1980.

Regardless of who wins the next presidential election, deficit spending will worsen. That is not to mention state spending, such as generous home-purchase proposals for migrants in California and Oregon.

Oliver says that if we are living through a repeat of the 1970s, investors shouldn’t expect a cataclysmic collapse of the stock market despite “ridiculous” valuations. Stocks would instead lurch higher and lower within a trading range for the next decade, ending at roughly the same nominal price but worth 90% less, he says.

In the scenario Oliver lays out, gold as a baseline reference to the dollar will reveal the true measure of monetary carnage. The metal rose twenty-four fold from 1971 to 1980, and he notes gold went from representing 12% of the Fed’s balance sheet to 133% in the final dollar panic. Because gold currently represents just 8.8% of the Fed’s assets, it would need to jump 36% to $3,300 an ounce just to get to the 1970 low, Oliver says. Foreseeably, gold’s value, as measured in dollars, could be much higher.

Gold at $3,300 or more is no longer far fetched. Societe Generale chief FX strategist Kit Juckes says that since the start of 2020–during which period gold has gained 57% against the dollar–super-easy global monetary policy, downward pressure on inflation-adjusted yields resulting from post-Covid inflation, and geopolitical uncertainty have driven gold’s performance.

More recently, a new source of potential support has been creeping in. “There is increasing speculation that the dollar's hegemony in the international financial system is being eroded, partly because the U.S. government is using it as a tool to police international behavior, and partly because the global economy itself is splintering,” he says, referring in part to the seizure of Russian assets in response to the country’s invasion of Ukraine,”says Juckes.

An inevitable catch-up by investors in the West may be imminent. Boockvar, who remains long and bullish on gold, calls it “amazing” that Western investors have “completely missed the rally [in gold], as measured by the 23 million ounces of gold taken out of all the gold ETFs over the past few years.” That process started just as the Fed was hiking rates in March 2022, when investors favored interest-bearing bonds instead of gold. “At some point, that Western investor will be back and will kick start the next leg higher in gold,” Boockvar says.

In his most recent annual report, Ronnie Stoeferle of the gold hedge fund Incrementum lays out stats that underline Boockvar’s point. Here are some. Data from investment company Asset Risk Consultants show that 75% of money managers surveyed have minimal-to-no gold exposure, with none exceeding 10%. A Bank of America study from late last year showed that 71% of U.S. financial advisors allocate less than 1% of their clients’ portfolios to gold. That compares to a rule of thumb that gold represent 2% of an investor’s net worth. Stoeferle points to academic and industry research, plus his own quantitative analysis, to recommend a gold allocation between 14% and 18%.

Investors are familiar with the “cleanest dirty shirt” argument, where presumed dollar supremacy is based on bigger problems abroad. But that view is increasingly too narrow. Already, interest payments on the debt represent about 40% of tax receipts, and it is unlikely that any new administration will dial back spending–especially as unemployment rises. Investors should at least entertain the possibility of a regime change as fiscal irresponsibility, inflation and unlawful asset seizures swirl to undermine the dollar.

Perhaps what is old will be new once again.

A Recession Warning Likely To Come Friday Will Be Widely–and Mistakenly–Dismissed (July 30, 2024)

New research challenges assumptions that layoffs are as low as believed, raising questions over the strength of the labor market

By Lisa Beilfuss
July 30, 2024

July jobs numbers due on Friday will likely stir economic growth concerns if for no other reason than it will only take a small rise in unemployment to trigger a popular recession indicator. Investors should be skeptical of dismissive analysis.

Named for economist Claudia Sahm, the Sahm Rule sets off when the current three-month average of the unemployment rate is half a point above the lowest three-month average of the past 12 months. The logic is that when the unemployment rate starts rising, it often picks up steam, Sahm says. By its nature a lagging indicator, it suggests a recession is already underway when it hits 0.50. 

The Sahm rule stands at 0.43, according to data from the St. Louis Fed. A tick in the unemployment rate in July to 4.2% from 4.1% in June would trigger the indicator.  

Many economists are already brushing off the potential recession warning. Sahm herself has said the rule, with a near-perfect history, may not be accurate this time because “the swing from labor shortages caused by the pandemic to a burst in immigration is magnifying the increase in the unemployment rate.”

Economists at Goldman Sachs similarly say they are not so worried about the rise in the jobless rate, which in June rose to the highest level since November 2021. The main reason: A rising unemployment rate is normally accompanied by rising layoffs, but that isn’t currently the case. They say the increase in the unemployment rate has instead come partly from a surge in labor supply driven by immigration.

The official data appear to back up Goldman’s point. The four-week moving average for initial filings for unemployment insurance is 235,500, up 10% from three months ago but exactly even with the comparable week a year ago and nearly identical to the average over the five years leading up to the Covid-19 pandemic. 

Relatively low and stable initial filings for unemployment insurance have puzzled analysts suspicious of robust establishment payroll gains, regularly revised lower and at odds with much weaker household employment. But assumptions about historically low layoffs and immigration’s effect on unemployment may be more flawed than even skeptics have appreciated.   

Colby College professor Kathrin Ellieroth and Minneapolis Fed economist Amanda Michaud in a July paper identify a meaningful problem in job-market data that vastly overstates voluntary quits and understates layoffs. The duo developed a way to distinguish between quits or layoffs for flows from employment to what they call non-participation–or a full exit from the labor market, as opposed to unemployment. 

Labor-force exits have previously been categorized as voluntary quits, but Ellieroth and Michaud find that over 40% of all flows into non-participation are actually precipitated by layoffs. They add that the unemployment rate is slow to increase during recessions because the first wave of layoffs target those that will exit the labor force. 

The distinction is critical given that rising quits imply labor-market strength while rising layoffs suggest the opposite. The finding helps square seemingly low jobless claims with a rising unemployment rate. 

Here is another point worth mentioning. Ellieroth and Michaud note that both quits and the share of laid off workers exiting the labor force are procyclical, meaning labor supply increases in recessions. That idea makes it worth questioning whether some analysts and investors have gone too far in attributing rising labor supply to immigration and are thus too quick to disregard the rising unemployment rate as more a quirk than a problem. 

Now consider some research this week from investment management company Verdad Advisers. Analysts there say they have been focused on studying how macroeconomic signals can help predict expected returns across asset classes. To find the right analogues, they created what they call a measure of macroeconomic similarity using a range of economic signals including high-yield spreads, inflation, and the yield curve. 

The researchers then converted the economic data at each point into a vector, or a multi-dimensional mathematical object that represents a list of data points in a specific order. To measure how extreme each observation is, they calculated the distance between that vector and all historical vectors going back to 1960. The smaller the distance between two months of data, the more similar those moments are, and vice versa.  

Verdad found that today’s market conditions are most similar, in reverse chronological order, to the following eight periods: 2019, 2007, 2000, 1995, 1989, 1979, 1973, and 1969. They note that those periods were generally defined by conditions that encourage risk taking, such as tight high-yield spreads that lead to high-risk borrowing, subdued volatility that encourages leverage, and an inverted yield curve which means long-duration government bonds are less attractive.

The worrisome thing, they researchers note, is that four of the eight closest analogous periods preceded major market crashes within 12 months. Verdad highlights the 50% hit rate for negative forward 12-month S&P 500 returns and a negative average return over all eight analogues as impressive considering the S&P 500 has averaged a 9% annual return from 1969 to 2024.

Verdad acknowledges that their findings alone don’t mean we are on the precipice of the next great financial crisis. “But we do think this provides a more data-driven way to think about the macroeconomic climate than narratives drawn from cable news—and, in this case, the data seems to tell quite a different story than the popular narrative,” they say.  

The prevailing narrative will eventually change, but not until lagging data piles up and flawed assumptions are debunked.

Fed Easing Will Be Aggressive. What To Watch (July 9, 2024)

A handful of lesser-known indicators suggest monetary policy easing will be more dramatic than markets expect

By Lisa Beilfuss
July 9, 2024

A relatively bold call from Citigroup may be just the start of a rapid rethink around economic conditions and monetary policy.

Citi economists late last week predicted 200 basis points in rate cuts starting in September, with consecutive quarter-point cuts pulling the Fed funds rate down to 3.25%-3.5% by July 2025. The Fed itself forecasts a 3.9% to 4.4% policy rate at the end of 2025.

Citi’s call came before Fed Chairman Jerome Powell said during his semiannual testimony that a “considerable softening in the labor market” had brought the risks between inflation and growth into balance. The comments helped firm up expectations for a September rate cut, with odds now at 70%. But markets may be too focused on the timing of the first cut and underestimating how aggressive the Fed may actually be. The CME’s FedWatch Tool shows traders still place 65% odds on a Fed funds rate at or above 4% by next July.

As readers might expect, we think a soft landing is unlikely and that the true state of the U.S. economy is less rosy than Fed predictions imply. But many investors and policy makers are flying blind as typical recession signals–such as an inverted yield curve–have flopped and as falling survey response rates and substantial downward revisions raise data-quality questions. 

This week Praxis looked for ways to help investors find economic truth. 

It is worth noting that Powell described “considerable softening” in the job market despite still-robust nonfarm payrolls. Strategists debate which of the monthly employment report’s divergent surveys is more accurate–the stronger establishment nonfarm payroll or the weaker household employment survey–but Powell’s characterization suggests emphasis is on the latter. 

There are several signals to heed in the household survey. First, Citi economists warn that the closely-watched Sahm Rule recession indicator will be triggered in August if the unemployment rate continues to rise at its current pace. The rule has had a perfect record since 1970 and tends to trigger several months after the start of a recession.  

Second, long-term unemployment has risen for five consecutive months to the highest since February 2022, when the indicator was still recovering from pandemic lockdowns. What is more, the June jump in those unemployed for 27 weeks and over was the biggest since November 2020; over the past year, the number has risen by 399,000. As one trader notes, long-term unemployment is pernicious because the longer a person is unemployed, the harder it is to find a job. In most states, jobless benefits expire after 26 weeks.

Looking beyond unemployment gives potentially earlier clues. Consider construction. Dwindling construction investment is often a first sign of an economic downshift, and so it makes sense that many economists watch construction payrolls to mark economic turns. It is easy to think there is nothing to worry about: The latest jobs report showed residential building construction payrolls hit a new cycle high, coming in at the highest level since July 2007.

But construction payrolls look vulnerable–even as one construction worker in five is over 55, meaning firms are hanging onto workers longer than they otherwise might. Sales of new single-family homes dropped to a six-month low in May, U.S. construction spending fell in May for the first time in the past 19 months, and the pending home sales index fell for a second straight month to a record low. 

That is as the American Association of Architects’ architectural billings index, which leads nonresidential construction activity by 9 to 12 months, fell in May for the fourth consecutive month. Billings declined at firms in all regions of the country, and a significant drop in design contracts signals softness in the pipeline of new work, the trade group said.  

Now look at tax receipts. As Richard Farr of Pivotous Partners says, daily income tax receipts received by the U.S. Treasury are some of the timeliest data available. Some analysts have pointed to rising tax receipts as evidence that downturn concerns are silly; at the beginning of June, withheld individual income tax collections were up 4% year-to-date.  

Fast forward to the end of June. Farr says tax receipts fell 1.1% in June from a year earlier, and he warns that falling tax receipts coincide with consumer delinquencies. Farr notes that the data are volatile and can reverse quickly. He also acknowledges a 1.1% drop might not seem like a big deal. But when you consider average hourly earnings and consumer prices are respectively up 4.5% and 3.3% year-over-year, it is a notable divergence, he says. 

“How can tax withholdings be down when nominal sales and wages are up? This shouldn’t be possible. It speaks to something breaking,” says Farr. Coincidentally, the New York Fed’s latest household debt and credit report, released in May, showed that overall debt levels increased 1.1% in the first quarter. Delinquencies rose for the third straight quarter, with 9% of credit card balances and 8% of auto loans transitioning into delinquency.

Here is one more. Economist Jim Paulsen created the Walmart Recession Signal, or WRS, on the ideas that recessions are typically felt first and most dramatically by lower-income households, and that slowdowns push consumers toward discounters and away from luxury brands. The WRS compares Walmart’s stock price performance to the S&P Global Luxury Index. A rise in the WRS warns of possible recession. 

Paulsen then compares the WRS with corporate credit spreads. Since 2007, the WRS and corporate credit spreads have closely tracked. But when they have diverged, the WRS has proven correct. He gives two examples, caveating that the indicator’s history isn’t long. When credit spreads widened significantly in 2015-16, implying a recession was near, the WRS didn’t jump. And when tight credit spreads in the second half of 2019 suggested the economy was healthy, the WRS spiked in advance of the 2020 recession. 

The WRS and credit spreads have again diverged since the end of 2023, Paulsen says. Spreads have been tightening all year and remain close to historic lows, suggesting strong balance sheets and a lack of any significant financial pressure. The WRS has meanwhile been rising all year, currently standing at the highest level since the 2020 recession.  

Investors should prepare for deteriorating economic data to prompt Fed easing that may be more  aggressive than many expect. Citi’s call for two percentage points in rate cuts over the next year looks bold–for now. Conventional wisdom is that rate hikes have less bite because more households and businesses are shielded from rising rates. If the corollary is true, quantitative easing may return sooner than later.

What the Combination of Fiscal and Fed Policy Can Tell Investors (June 21, 2024)

A new “monetization impulse” metric is rising as budget deficits expand and QT slows. 

By Lisa Beilfuss
June 21, 2024

The latest spate of economic data are alleviating concerns over inflation. But a new way of measuring the interplay between fiscal and monetary policy suggests the slowdown in price increases will be short lived. 

May price data broke the streak of renewed, and largely unexpected, upticks in inflation. From a month earlier, the consumer price index was the lowest since July 2022, the producer price index fell at the fastest pace in eight months, and the import price index fell for the first time in five months. 

This all points to a 0.06% month-over-month increase in the Federal Reserve’s favorite inflation metric, the core personal consumption expenditure index, says Omair Sharif of Inflation Insights. That would represent the lowest print since November 2019–outside of March and April 2020, when the government shut down much of the economy–and it would pull the year-over-year core PCE down to 2.56%.

While a welcome development, relief over cooler inflation numbers misses the forest for the trees. More important news is that the Congressional Budget Office in the latest week raised its 2024 budget deficit estimate to $1.9 trillion from a February estimate of $1.5 trillion. What is more, the CBO projects that debt held by the public will rise from $26.2 trillion at the end of 2023 to $50.7 trillion at the end of 2034. As a percentage of gross domestic product, debt is projected to rise from 97.3% in 2023 to 106.2% by 2027,  surpassing the prior record set just after World War II. The CBO says that ratio will rise to 122.4% by 2034–about 25 percentage points larger than it was at the end of 2023, and two-and-a-half times its average percentage over the past half century.

Alarming as they look, budget-deficit and debt-to-GDP estimates are probably too optimistic. As Joe LaVorgna, chief U.S. economist at SMBC Nikko Securities notes, embedded in the latest CBO projections are estimates of federal revenue hovering around a historically high 18% of GDP. That is a reasonable assumption if the unemployment rate averages just 4.4% over the next decade as the CBO expects. But an economic downturn would push unemployment higher and revenue growth would collapse, as the government would concurrently spend more on programs such as unemployment insurance, LaVorgna says.  

It is intuitive that rising government spending would spur inflation. That is despite arguments to the contrary by proponents of modern monetary theory, or MMT, and after fiscal and monetary largesse in response to the financial crisis of 2007-08 didn’t produce inflation. A 2022 paper from the Bank of International Settlements helps frame the current reality.   

The strength of the deficit-inflation link depends on what kind of fiscal-monetary policy regime is in place, the authors say. Specifically, a higher deficit is least inflationary under a "monetary-led" regime, where the fiscal authority acts prudently to stabilize public debt, the central bank is “highly independent,” and the central bank faces strong legal limitations on its ability to lend to the public sector. By contrast, the greatest inflationary effect occurs under a "fiscally led" regime, where fiscal policy is profligate and the central bank is constrained only in a limited way from lending to the public sector. 

Crucially, the paper’s authors found that the high inflation of 2021 and 2022 “appears more consistent with a fiscally led rather than a monetary-led regime.”

Solomon Tadesse, head of quantitative equities strategies North America at Société Générale, has been warning about the kind of regime shift in the U.S. that the BIS described. He set out to develop an empirical link between fiscal and monetary largesse and inflation, and introduced what he calls the “monetization impulse” in a report this month.

Here it may be helpful to revisit the idea of debt monetization. Readers might recall how Tadesse has previously framed the issue for Praxis. 

There is direct monetization, in the form of an irreversible transfer of money from a central bank to the government or a purchase of debt securities by the central bank upon issue in the primary market. Direct monetization tends to occur in war-torn or developing countries, resulting in hyperinflation linked directly to currency printing.

Then there is indirect monetization. In developed countries, laws constrain the level of central bank involvement in government financing. As Tadesse notes, the Banking Act of 1935 prohibits the Fed from directly purchasing bonds from the Treasury. The Fed instead executes open-market operations by buying and selling Treasuries on the secondary market and purchasing government debt via quantitative easing programs. 

A key point Tadesse emphasizes is that QE isn’t automatically monetization in that it represents a temporary debt transfer to the public books that is reversible through quantitative tightening, when the Fed lets maturing government bonds mature instead of reinvesting the proceeds. But a lack of follow-through with QT means the debt remains on the balance sheet and is effectively monetized.

With his monetization impulse Tadesse focuses on potential debt monetization, which goes beyond deficit financing by the Treasury to include all forms of monetization related to the funding of government programs, such as government bond purchase programs conducted by the Fed and accompanying temporary credit facilities.

A logical point for measuring potential maximum monetization is the size of the total federal debt financed by Fed banks, Tadesse says. That amounts to about $5.2 trillion, down from a peak of about $6.2 trillion in the first quarter of 2022. But while potential monetization is down from its recent peak, it is well above a pre-pandemic level of under $3 trillion and a pre-financial crisis level of under $1 trillion. 

The Fed is financing an increasing share of rising U.S. debt, jumping from about 5% of GDP historically to about 18% currently. QE-driven debt transfers account for the big rise, Tadesse says. At the same time, the central bank announced in April that it would slow the pace of QT this month–a hint the program is coming to an end after only about $1.7 of the roughly $5 trillion in pandemic-related debt has fallen off its balance sheet. The balance sheet stands at $7.3 trillion; for context, it was under $1 trillion before the 2007-08 financial crisis. 

The increase in potential debt monetization has caused money supply growth to skyrocket, Tadesse says. Over the post-pandemic period, debt (adjusted for real GDP growth) has gone up by an annualized 7.7%, while the monetary base, or M0, has risen 13% and M2 money supply has increased 73%. Over the post-GFC period since 2007, he says debt and money-supply growth rates have followed similar patterns. The point is that monetary growth in excess of inflation-adjusted GDP has more than kept up with debt growth, suggesting monetization of the U.S. debt. 

Now, the monetization impulse is hooking higher at a time when QT is slowing and the deficit is rising.

“The monetization impulse is currently accelerating, heralding days of potentially persistent inflation,” Tadesse says. The metric closely tracks the path of realized inflation, with its turning points leading inflation peaks and troughs by roughly six months. One useful upshot: Tadesse says real assets–including commodities, real estate and equities focused on natural resource-related investment–perform significantly better during accelerating monetary-impulse phases going back to the 1970s.

It makes sense that central bankers and investors would find relief in the latest round of inflation data. But in the context of growing budget deficits and central bank financing, cooler inflation numbers may prove little more than a temporary reprieve.

You’re Going to Hear More About “Harmonizing” Inflation. Why It Matters (June 5, 2024)

There is a push to drop the biggest, and most inconvenient, component of major inflation indexes. It may mean quicker rate cuts now–and more payback later.

By Lisa Beilfuss
June 5, 2024

There is a nascent push underway to “harmonize” inflation in the U.S. Investors should consider that a euphemism for eliminating the biggest component of major inflation indexes, which would allow officials to declare victory over inflation for now.

Investors already familiar with “harmonized inflation” might think of it as what the Europeans do to create a measure of inflation that is comparable across countries. Different preferences mean, for example, that olive oil is weighted more heavily for some countries than butter. Those advocating harmonizing U.S. inflation data are narrowly focused on one feature of the Euro area’s Harmonized Indices of Consumer Prices, or HICP. Where U.S. inflation indexes include owner-occupied housing in the form of owner-occupied rent, or OER, the European version altogether excludes the category.

OER is based on what homeowners say it would cost to rent their own homes, and it is how government economists turn housing, an asset, into a service. The component is weighted heavily in major U.S. inflation baskets, comprising 34% of the core consumer price index and 13% of the core personal consumption expenditure index. OER rose at a 5.8% annual pace in April, down from 8% a year earlier but still about double the pre-pandemic rate and triple the Federal Reserve’s overall 2% target. 

Stubbornly high OER is a key roadblock to rate cuts, at least when one is simply looking at the inflation side of the central bank’s mandate. Not surprisingly, OER is drawing increased attention and criticism. As economists at Goldman Sachs put it, the largest component of the CPI tracks a price that nobody actually pays–an imputed rental payment from homeowners to themselves. The idea is that OER is derived from observed rental prices in nearby similar homes, which can be tricky when about two-thirds of Americans own their homes.  

It makes sense, then, that an effort would be afoot to nix the OER from the CPI and PCE for the purpose of monetary policy decisions. That effort may gain momentum as other central banks begin easing and downward inflation forces in the U.S stall or reverse. Consider a four-month string of import price increases suggesting goods disinflation may already be exhausted, and Deutsche Bank’s estimate that the immigration surge knocked a half-point from core PCE from the immigration surge. 

Economists at Moody’s Analytics are emphasizing harmonized inflation. Matt Colyar, economist there, published a recent report noting that while the CPI was up 3.2% in the first quarter relative to a year earlier, its harmonized version was up 2.3%. Core CPI (which excludes food and energy) rose 3.8% in the first quarter, compared with a 2% increase in the harmonized version.  

What is more, Moody’s recently developed a harmonized version of the total and core PCE, the latter of which is the Fed’s preferred inflation metric. The firm’s harmonized core PCE has been running below 2.5% since September and was up just 1.7% in March. 

Colyar says the purpose of creating the new harmonized PCE isn’t to promote the idea that the Fed should shift to targeting a new measurement, and he says it isn’t an exercise in excluding inconvenient components from inflation estimates. Even so, he says that if the U.S. government measured inflation the way the European Union does, the Fed would likely have already started loosening monetary policy. 

Cherry-picking data or excluding components to justify policy isn’t new or unusual. But potentially harmonizing U.S. inflation metrics in order to exclude OER and superficially achieve 2% inflation is particularly problematic. 

First, OER may be broadly misunderstood. It is a misnomer that the Europeans exclude owner-occupied housing from inflation metrics because it is flawed. Omair Sharif of Inflation Insights says the Euro area’s HICP excludes the component in part because of practical issues such as differing regulations and high shares of public housing in some European countries.  

What is more, Sharif notes that the EU has said it is working to include owner-occupied housing in its inflation index. That point itself exposes calls to harmonize U.S. inflation metrics as somewhere between disingenuous and illinformed. 

Second, it is conceptually flawed to strip out owner-occupied housing inflation from major inflation gauges. As economist Ethan Harris says, the flow of services from owner-occupied housing (where OER is one way to measure it) is an important contributor to overall consumption. Home prices, according to the Core-Logic-Case-Shiller home price index, rose 45% from January 2020 to June 2022. They dipped 5% for the next seven months and since then have been rising at about a 7% annualized pace. Those gains don’t exist in a vacuum. One example: The average cost of home insurance rose 11.3% in 2023, according to S&P Global.  

Third, if U.S. policymakers were to advance harmonized versions of major inflation indexes, they would widen the gap between official inflation metrics and the reality of households and businesses. The mismatch already exists because consumers can’t back out the costs of food and energy, each of which are already excluded from core inflation gauges.   

It is possible that growth data deteriorate faster than a push to harmonize inflation data materializes. Consider the latest data from the Job Openings and Labor Turnover Survey from the Labor Department, which showed that the number of job openings per unemployed fell back to pre-Covid levels. That is a development the Fed will be happy to see, says Juliette Declercq of JDI Research, given the emphasis central bankers have put on JOLTS data and that particular ratio. “But be careful what you wish for, because there is no stabilization in sight,” she says.

Either way, investors should pay attention to efforts by some economists and policymakers to “harmonize” U.S. inflation data for the purpose of excluding the big and currently inconvenient owner-occupied rent component. Such discussions will help reveal policy preferences and potentially pave the way to quicker rate cuts now–and more dramatic payback later.

What Attempts To Exclude Government Spending From Economic Data Tell Investors (May 20, 2024)

If the robust U.S. economy is a debt mirage, expectations for higher long-term interest rates are folly

By Lisa Beilfuss
May 20, 2024

Explosive government debt isn’t a new or undercovered story. But here is a statistic that recently caught our attention: Every dollar of fourth-quarter U.S. GDP growth was bought with $2.50 in new debt issued by the U.S. government.

The stat is from the 2024 In Gold We Trust report by Ronald-Peter Stoferle and Mark Valek of Incrementum AG. As they put it, the U.S. economy is being pushed to peak growth levels largely by the use of “economic steroids.” 

Boiling the U.S. fiscal situation down in this simple way makes the problem more palpable. This week we dug into two veins of related questions to help investors better evaluate economic data and anticipate the direction of policy. First, what does the U.S. economy look like when the government is excluded from growth metrics? Second, how realistic are widespread assumptions about higher long-term interest rates?

It isn’t possible to fully back out the impact of government spending on gross domestic product. But Peter Earle and Thomas Savidge of the American Institute for Economic Research have attempted to untangle the government from the private sector. Last month they published an analysis of economic performance “without government spending muddying the water.”

Using data from the Bureau of Economic Analysis, Earle and Savidge provide new calculations of gross domestic private product, or GDPP. This measure is obtained by subtracting government consumption expenditures and government gross investment from GDP, leaving personal consumption expenditures, business investment and net exports. The approach is imperfect because it doesn’t exclude transfer payments such as Social Security or unemployment insurance, as those payments are counted as private spending. Nor does it consider the impact of government debt, which weighs on economic growth, or the impact of historically expansive monetary policy.  

Even so, the analysis shows GDPP has slumped and the gap between GDP and GDPP has widened. AIEA finds the average annual growth rate of GDPP prior to 2000 was 3.63% while the post-2000 average was 2.34%. GDPP has been growing 35% slower per year since 2000, Earle and Savidge say, and their results likely overstate reality given they can’t fully exclude the impact of government spending. 

Here is another way to look at the economy excluding government spending. The BEA last reported a personal savings rate of 3.2%. That is below a 12-month average of 4.3%, below a post-Covid average of 8.3%, and about half of the average savings rate in the five years before massive pandemic stimulus. Still, private survey data make the official savings rate from the BEA look high. Here are two examples: First, a 2023 survey by Payroll.org said 78% of Americans live paycheck to paycheck, up 6% from 2022. Second, a LendingClub report in late 2023 showed 62% of Americans live paycheck to paycheck, including more than half of households earning over $100,000 a year. 

Richard Farr, chief investment officer at Merion Capital Group, offers a way to square a positive, if falling, savings rate with conflicting private reports. The savings rate is based on disposable personal income. When the BEA calculates personal income, it adds federal entitlement spending. In other words, the savings rate reflects government transfers–not just earned income. 

“If income isn't actually income, then ‘savings’ can't be savings,” he says. If all entitlements such as Social Security, Medicare and Medicaid were backed out, Farr says the savings rate would fall from roughly positive 3% to roughly negative 7%. “Is our robust economy simply a debt mirage?” Farr asks. 

Debt mirage or not, it is unrealistic to expect politicians to dramatically cut spending anytime soon. Therein lies what is probably the answer to a separate question around prevailing interest-rate expectations.

Many economists argue that the long-run natural rate of interest—or the inflation-adjusted short-term interest rate when an economy is at full strength and inflation is stable–has risen significantly after being stuck around 0.5% for the past 15 years. That is the rate often referred to as r-star, and it is key to setting monetary policy and informing investment decisions. (If inflation runs at 2% a year, then you get what has been the Fed’s projection of 2.5% for the long-term Fed funds rate).

RSM chief economist Joe Brusuelas argues that r-star is now closer to 2% than 0.5%. If the inflation target remains at 2% and is respected, that translates to a 4% terminal Fed policy rate. Behind his estimate is a view that investments in infrastructure, domestic manufacturing capacity and environmental sustainability are creating the conditions to improve productivity and lift potential growth. The bottom line, says Brusuelas, is that the era of extremely low interest rates has ended. 

But the logic is circular, at least in part. Infrastructure investment and environmental sustainability have been particular targets of government spending. Now, there is a bipartisan push in the Senate to spend at least $32 billion over the next three years to develop AI, a key source of productivity growth expectations.

As David Rosenberg of Rosenberg Research notes, the Federal Reserve has the power to ease or exacerbate the federal government’s fiscal woes via its interpretation of r-star. He highlights the interest-expense-to-revenue ratio, what he calls the public sector version of the interest coverage ratio, as the key fiscal metric to evaluate what happens when you combine a higher for longer interest rate stance with high and rising public debt. 

“Put together high debt levels and high rates, and you get a very rapid deterioration in interest coverage. What’s more, it lasts; the government needs to supply assets at maturities along the full yield curve, so those higher expenses get locked in for years to come,” says Rosenberg. He notes that the period of high interest rates between roughly 1975 and 1985 caused the interest-expense-to-revenue ratio to double a decade later, even as the government was running surpluses and reducing the debt. 

Even partially backing out fiscal spending reveals slower growth and questionable productivity, suggesting the government will increasingly need to spend more to maintain output growth. Doing so crowds out private-sector growth and burdens younger generations, underpinning the vicious cycle. The era of low rates isn’t so much an era, then, but an ongoing political and economic reality. The irony is that for the economy to withstand higher long-term interest rates, the government must seriously address its profligacy.

Why An Under-the-Radar Recession Warning May Be A Bullish Sign (May 7, 2024)

Michael Kantrowitz of Piper Sandler says his 10% Rule triggered on April unemployment data, setting up new highs for stocks as bond yields fall

By Lisa Beilfuss
May 7, 2024

Many investors and strategists are patiently waiting for a widely followed recession indicator to trigger before preparing for a downturn. The attention may be misplaced. 

As market participants try to decipher if and when an economic downturn will unfold, the Sahm Rule has become a focal point of the recession debate. Developed in 2019 by economist Claudia Sahm, the eponymous indicator triggers when the three-month moving average of the unemployment rate rises by 0.5 percentage points or more relative to its low during the previous 12 months. 

After last week’s jobs report showed that the unemployment rate ticked up to 3.9% in April from 3.8% in March, the Sahm Rule rose to 0.37, its highest reading of the current cycle.

The Sahm rule has already triggered in 20 states, notes Charles Schwab chief investment strategist Liz Ann Sonders. The Sahm Rule is calibrated for the national unemployment rate. But, as Arch Capital Group chief economist Parker Ross says, applying the rule at the state level does a good job of mimicking the national-level rule.

All of that said, those waiting for the Sahm Rule to officially trigger will probably wind up behind the curve. According to Sahm herself, the Sahm Rule isn’t a forecast but a confirmation. Former Federal Reserve economist and recession forecaster Arturo Estrella notes that when the Sahm Rule has risen to the 0.3-0.4% range, it has always breached 0.5%--but only within seven months after the start of recession.  

Here is a potentially better indicator to heed. Michael Kantrowitz, chief investment strategist at Piper Sandler, says the latest unemployment data sparked his simple 10% recession rule, where the year-over-year change in the three-month moving average of unemployed persons is above 10%. 

Kantrowitz’s rule uses unemployed persons, the numerator of the unemployment rate. Sahm has warned that rising labor supply, in part because of immigration, could “break” her rule this cycle. In contrast, the 10% rule is unaffected by labor force participation. 

The 10% rule has never misfired. In the six recessions since 1980, it has triggered an average 3 months after a recession was later determined to have started. Extrapolating with April data suggests a recession may have started in roughly January.

This is where the good news starts. As Kantrowitz puts it, the market’s enemy today is higher inflation. The enemy of higher inflation is higher unemployment. Higher unemployment is thus the market’s friend as it would likely bring down inflation and interest rates, he says. 

Upside surprises this year in both growth and inflation data have significantly reduced Fed rate-cut expectations. Markets remain at the mercy of bond yields, and Kantrowitz notes that every stock-market pullback over the last two years has occurred amid a spike in interest rates. At this point the bond rally of last winter has nearly fully reversed, reigniting concerns around housing, commercial real estate, regional banks, government debt and small companies. A continued rise in rates, or even just interest rates that hold higher for longer, increases the odds that those concerns become more imminent market threats.

Cracks in the labor market are starting to get more mainstream attention. Apart from the April rise in unemployment, consider some additional recent metrics. The latest Job Opening and Labor Turnover report showed that job openings fell to the lowest since February 2021, hiring dropped to the lowest level since the pandemic, and quits declined to the lowest level since January 2021. That is as outplacement firm Challenger, Gray & Christmas said company hiring plans dropped 58% in April from a year earlier, to an 11-year low.  

With investors worried about higher rates, Kantrowitz says it wouldn’t take much in the way of softer data to unlock what he calls a “coiled spring” and see stocks and bonds rally and yields fall.  “Cuts will be here before you know it if the trend continues .. and I think it will. The Fed won’t wait for inflation if this continues,” he says. 

Kantrowitz goes back 60 years to study seven recessions. He says many investors may be missing the current bullish signal because they are focused on what happened during the more recent recessions of 2001 and 2007, where stocks fell alongside lower interest rates. But those downturns are incorrect analogs, he says, because growth–not inflation–was the problem. When inflation is the bigger problem, markets have historically risen as soon as rates fall. 

He predicts that the past few months of both higher rates and commodity prices will lead to softer macro data for May, setting the table for fresh all-time highs in stocks. 

Now for a caveat. Kantrowitz identifies between 3% and 4% as the sweet spot for interest rates. That is to say a moderate decline in rates that is not from a crisis would boost most stocks, especially bond-sensitive areas.  But rates below 3% would suggest economic data and corporate earnings have significantly weakened. Even worse for stocks, he says, are rates below 2.5% because it would imply a very hard landing.

Kantrowitz warns that bears should be wary of expressing their macro views on equities today. That will inevitably change, but probably not before new highs. For now, stock investors may have an underappreciated window for further gains.  

Tapering QT Will Be About Easing, Not Prolonged Tightening (May 1, 2024)

A slowdown in the pace of balance-sheet runoff may come as inflation fears appear overblown and growth cracks spread

By Lisa Beilfuss
May 1, 2024

When the Federal Reserve announces plans to taper quantitative tightening, officials and strategists will say that doing so enables QT for longer and will thus lead to a bigger unwind of massive pandemic-era bond purchases. 

That interpretation probably won’t be right. In reality, the slowing of QT will be tantamount to the beginning of the easing cycle, which will be necessary sooner than many expect.

After $5 trillion in quantitative easing more than doubled the Fed’s portfolio, the Fed has let roughly $1.5 trillion in Treasuries and mortgage-backed securities roll off its balance sheet. The Fed’s portfolio is still equivalent to about 27% of U.S. gross domestic product. Many on Wall Street expect the Fed to halve its runoff cap for U.S. Treasuries to $30 billion a month, starting June 1. (Runoff of mortgage-backed securities, or MBS, is already limited by relatively high interest rates, so many expect the Fed’s MBS cap to be held at $35 billion a month).  

The result of QT is a loss of bank reserves and deposits, which reduces liquidity in the banking system and weighs on financial markets. When the Fed met in March, the "vast majority" of Fed officials said it was prudent to “fairly soon” begin slowing the pace of balance-sheet runoff. The rationale included future declines in overnight RRP balances, or the amount of cash parked at the Fed overnight reverse repo facility. The Fed uses the RRP to set a floor for the fed funds rate, and the facility is often considered a proxy for overall bank reserves and system-wide liquidity. 

What is more, “bank reserves have had a suspiciously strong relationship with stock market performance in the QE/QT era,” says Piper Sandler’s chief global economist Nancy Lazar, as abundant reserves have kept financial conditions easy and supported stocks. This relationship didn’t exist before the introduction of quantitative policies, she says, noting that bank reserves dipped in April. 

Because slowing the pace of balance-sheet rundown would keep bank reserves higher and long rates lower, officials such as Dallas Fed President Lori Logan have said that tapering QT sooner would reduce the likelihood the Fed would have to stop QT prematurely.

But that argument is “hocus pocus,” says Stephen Miran, fellow at the Manhattan Institute and former senior advisor at the Treasury Department. “QT is monetary policy and reducing it is an easing of monetary policy.”  

Effectively beginning the easing cycle now seems awkward, to say the least. Inflation data have been consistently hot since the start of the year. The Fed’s preferred measure, the core personal consumption expenditure index, is running a full point below the core consumer price index. Yet the core PCE was still up 2.8% in March from a year earlier, nearly a point above the Fed’s stated target. 

The Employment Cost Index dealt the latest blow when it rose a faster-than-expected 1.2% in the first quarter of this year versus the fourth quarter of last year. The ECI, which includes non-wage compensation and benefits, is considered the gold-standard metric of worker pay because it is the broadest measure of how much an employee costs.

But it is worth digging into the data. Quarterly inflation numbers appear front-loaded, if the monthly PCE figures are a guide. Omair Sharif of Inflation Insights notes that the core PCE for January was revised up to 0.5% from 0.45%, while February was revised up just slightly to 0.27% and March came in at 0.32%.  

And some have poked holes in the latest ECI. Sharif says sectors that account for 61% of total employment either decelerated or were unchanged in the first quarter. The ECI combines hours worked and wages, and Michael Green, chief strategist at Simplify Asset Management, notes that the number of hours worked fell in the first quarter. Hours worked is considered a leading indicator because employers often cut hours before conducting layoffs. Economists at Goldman Sachs say compensation growth was again disproportionately strong among unionized workers–what they say is a lagging indicator because union workers' contracts adjust less frequently. 

Now take a step back. Contrary to conventional wisdom, economist Jim Paulsen says we simply lack the “policy fuel” necessary for inflation to again become problematic. He uses an indicator called Total Policy Stimulus, or TPS, which combines what he calls the four major policy tools: monetary policy, fiscal policy, the U.S. dollar, and bond yields. The TPS adds annual money supply growth and the ratio of fiscal deficit spending to GDP, then subtracts the annual change in bond yields and the annual percent change in the U.S. dollar. 

Since mid-2023, Paulsen says “fiscal juice” has declined by about 2.5%. That is as both bond yields and the dollar have tightened in recent months. “Inflation has again been receiving a full dose of restrictive force,” says Paulsen, warning that the TPS is about to begin declining again this summer. 

While Paulsen says the relationship between inflation and the TPS indicator is far from perfect, it has done a good job indicating the level and direction of inflation one year in advance. Based on the TPS, Paulsen says he thinks the annual CPI inflation rate is headed between 0 and 2% in the next year.

Now consider some recent disappointing growth markers alongside Paulsen’s TPS indicator. The Treasury said it must borrow more than had been expected in the second quarter because tax receipts have disappointed. The Conference Board’s measure of consumer confidence fell to the lowest level since July 2022. 

The weakening NFIB small business survey has suggested much slower job gains from the second quarter onwards, and the S&P PMI employment index is now telling the same story, says Ian Sherpherson of Pantheon Macroeconomics. He notes that while the NFIB leads by about four months, the S&P PMI jobs measure is more of a coincident indicator. All this is as a host of companies, such as Starbucks and McDonald’s, report flagging consumer demand.

One final point: Greg Barker of the financial newsletter Concoda suggests QT–launched in June 2022–is only just starting to bite. The idea is that until recently, Treasury Secretary Janet Yellen has been offsetting the impact of balance-sheet reduction via easy-to-absorb short-term bill issuance. At the same time, a big Treasury General Account drawdown pushed bank reserves back into the system, adding liquidity and pushing stocks higher. 

But the tide is now turning, Concoda says. Yellen is now issuing more Treasuries with longer maturities and more duration risk, potentially forcing buyers to sell riskier assets to counteract the increased risk they are bearing. “Tighter quantitative tightening has been activated, unleashing a stealth tightening effect on markets,” says Concoda.

Market implications of tighter QT, mounting growth cracks, indications that inflation isn’t looking quite as bad as some fear, and a Fed that has a tolerance for above-target inflation all support the conclusion that monetary policy easing may start sooner than later. Regardless of how officials frame it, such easing may first arrive in the form of tapered QT– which is at least as important as interest-rate cuts upon which most are focused. 

Why the Fed’s Inflation Target Is More Rhetoric Than Reality (April 21, 2024)

History shows prices have long exceeded the 2% target. The number is haphazard and the timing undefined.  

By Lisa Beilfuss
April 21, 2024

If actions speak louder than words, it may be fair to say that the Federal Reserve’s commitment to a firm 2% annual inflation target has long been illusory. Many investors may thus be underestimating the central bank’s current inflation tolerance.

After the latest round of inflation data dashed hopes that accelerating prices in the first two months of the year were blips, many economists flipped into the no-interest-rate- cuts-this-year camp. Some are going further to say more monetary policy tightening is warranted. 

But it is worth taking a step back. Consensus expectations for Fed policy are built on the Fed’s stated commitment to its 2% inflation target. “The Committee is strongly committed to returning inflation to its 2% objective,” the central bank’s policy setting committee has said in each of its post-meeting statements since June 2022. After decades of deliberation, the Fed established its explicit target under Ben Bernanke in 2012. The long debate back then is relevant to circumstances now.

Matthew Wells of the Richmond Fed describes how the inflation-target debate started and evolved. Alan Greenspan in the mid-1990s tasked Al Broaddus, then president of the Richmond Fed, to make the case for a target. Among his arguments: the Fed’s credibility rested not only in managing actual inflation, but in its ability to shape inflation expectations. A target could help anchor inflation expectations, and prices themselves, providing markets with more certainty around Fed policy and price stability.

Greenspan meanwhile tapped current Treasury Secretary and then-Fed governor Janet Yellen, first appointed in 1994, to present arguments in opposition of an inflation target. Yellen’s arguments centered on concerns that such a target would cause monetary policy to prioritize inflation over employment. 

Wells says that in July 1996, after officials seemed to secretly settle on 2%, Greenspan reminded members to keep the discussions confidential. “With an eye on potential political and market blowback, [Greenspan] warned, ‘I will tell you that if the 2% inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate.’” Among them: being on the hook to effectively cause unemployment when inflation runs above target.

Flash forward to March 2007, after Bernanke succeeded Greenspan as Fed chair. Some officials, such as then-Dallas Fed president Richard Fisher, altogether opposed the idea of an inflation target. Yellen, then San Francisco Fed president, came to favor a target range of up to 3.5% and preferred it be a long-run goal and not bound by a fixed time horizon. Bernanke argued that 2% would be “the lowest inflation rate for which the risk of the funds rate hitting the lower bound appears to be acceptably small.” Yet it didn’t take long for rates to hit the zero lower bound, where they stayed for six years, and for the Bernanke Fed to concurrently launch massive bond-buying programs.

A walk through the history of inflation targeting, which often credits New Zealand’s central bank for creating the 2% target to establish independence from the political process, makes it clear that 2% is somewhat arbitrary. Don Brash, atop New Zealand’s central bank when the target was adopted 35 years ago, reportedly said the number was “plucked out of the air.” 

Now consider Fed Chair Jerome Powell’s new emphasis on getting inflation back to 2% “over time.” In his March press conference, he used the phrase in that context eight times in the hour-long session. If the number is haphazard and the timing is undefined, the trusted 2% target seems hollow.

This isn’t altogether new. I recently revisited a data set I first wrote about in November 2021. The New York Fed’s Underlying Inflation Gauge, or UIG, sought to measure persistent inflation. This measure typically comes in lower than the CPI and PCE. The indicator was last released in October, at which point it was discontinued. 

At its last measurement, the  UIG fell to an annual pace of 2.9%. That is down significantly from a peak of 6.3% in June 2022. But it was still well above the Fed’s 2% target–which is based on core, as opposed to persistent, inflation–and it came before inflation began to reaccelerate.

What is more, the UIG shows how comfortable the Fed is with above-target inflation. The last print simply put the gauge back to mid-2018 levels. Despite the narrative that for years before the pandemic the Fed couldn’t get inflation off the floor, the UIG averaged 2.5% in the year before the pandemic, 2.6% in the two years before the pandemic, and 2.5% in the three years before the pandemic. And that is just underlying inflation, as opposed to total inflation. The UIG undershot CPI by an average of 62 basis points for 2023 before it was scrapped and by an average of 200 basis points and 100 basis points for 2022 and 2021, respectively.  

Central bankers are expressing particular concern over housing inflation. "I have been expecting [shelter inflation] to come down more quickly than it has. If it does not come down, we will have a very difficult time getting overall inflation back to the 2% target," Chicago Fed President Austan Goolsbee recently said.

Some say that using private data instead of the government’s shelter measure is more accurate. Plugging in Zillow’s observed rent index pulls the March CPI down to 2.7% from 3.5%. But using the Zillow gauge also means that CPI in the years leading up to the pandemic trended closer to 4%. 

Here is a real-world anecdote behind the data. Gavin Campbell, founder of real estate private equity firm Steelbridge, says his firm’s annual apartment and single-family home rental growth for the 10 years preceding the pandemic was never below 3%. Renewals, which represent 70% of Steelbridge’s leasing, never grew below 4% annually. 

“Rents in our portfolio bottomed a year ago [and] are only going up from here,” Campbell says. In addition to strong job growth, he says high mortgage rates are driving the increases. “Don't expect any CPI help from shelter absent a recession or interest rate cuts from the Fed,” he says. 

Last week, the Labor Department said its new all-tenant rent index rose 5.4% in the first quarter, matching the fourth quarter’s gain. Rick Palacios, research director at John Burns Research & Consulting, says single-family asking rent growth is 4% or more in 54 of the 99 markets the firm tracks.Las Vegas is the only market declining, and just barely.  

All of this may help answer a question posed by former Fed economists Robert Brusca. How can a central bank retain credibility if, instead of defending an inflation target it has overshot for two-and-a-half years, it defends an unemployment rate that is near a half-century low? 

If the 2% inflation target has always been more about perception than reality, without reality matching perception, then now might be a good time for investors to doubt consensus expectations for Fed policy.

How the Fed Might Justify Rate Cuts in the Face of Hot Economic Data (April 8, 2024)

Some economists are already setting the stage for cuts, despite strong payrolls data

By Lisa Beilfuss

Economic data are complicating the Federal Reserve’s plans to cut interest rates this year. Something has to give, and it could be the data that officials choose to emphasize.

The March jobs report makes it harder to argue that the U.S. economy warrants interest-rate cuts anytime soon, even if fiscal policy is driving labor market gains. Alongside the much better-than-expected nonfarm payrolls number, the report showed an even bigger gain in the household survey and a positive net revision for January and February payrolls. That is to say that two elements of the bear case–disappointing household employment and negative revisions–flipped in March. 

It is possible that another strong jobs report, together with a renewed rise in inflation, delays the start of the Fed’s easing cycle until late this year or next year. 

But that outcome would require the central bank to prioritize its 2% inflation objective above reasonably presumed constraints, such as rising interest on government debt and the challenge higher yields pose to the Treasury market and banking system. That isn’t to mention the reality of election-year politics. Washington knows the incumbent party loses the White House every time there’s a recession quarter in an election year, notes Piper Sandler’s Nancy Lazar.

It is instead possible that central bankers begin to shift investors’ attention away from nonfarm payrolls and toward alternative labor-market measures in an effort to justify rate cuts. Powell has already done this on the inflation side by emphasizing “supercore” price indexes excluding food, energy and shelter.

Officials have cover to cast doubt on the reliability of the nonfarm payroll series. It seems no one really yet knows how immigration is affecting the employment figures, and the falling response rates to government surveys, by now well publicized, are rendering the data less reliable and subject to significant revisions.

There are subtle clues that this scenario may be about to unfold. Economist and Harvard professor Jason Furman, who was a top economic adviser to Barack Obama and worked in the Clinton administration, threw cold water on the usefulness of payrolls Friday. 

“I've given up on using job growth to assess anything regarding inflation or overheating,” Furman tweeted after the jobs data dropped Friday. 

Consider as well a tweet Friday from economist Ernie Tedeschi, who was until recently President Joe Biden’s chief economist at the White House Council of Economic Advisers. “The U.S. economy is clearly growing at a strong pace. The question for the Fed is how much of this growth is supply-driven,” Tedeschi wrote. 

Tedeschi’s comment is reminiscent of the logic behind transitory-inflation arguments that began in 2021. Then, “transitory” proponents argued that price increases were about pandemic-related supply disruptions and not about demand.

Now, Tedeschi is talking about a potentially massive increase in labor supply due to immigration. He points to a recent report from the Hamilton Project that says projections from the Congressional Budget Office suggest the trend in jobs growth because of immigration and is now closer to 200,000 a month, up from a prior 100,000.

“The difference between trends of 100,000 and 200,000 a month has profound implications for policy. The former means the labor market is hot and has plenty of momentum. The latter means we're much closer to a sustainable equilibrium and should be more wary of risks of overly-tight policy,” Tedeschi says. 

Adopting the kind of thinking put forth by the likes of Furman and Tedeschi would help the Fed explain rate cuts if they really are intent on easing policy in the face of strong headline data. Key to this scenario would be the Fed’s redirection of investors’ focus from nonfarm payrolls to alternative labor-market measures, such as employment data from the Institute for Supply Management.  

In March, both the ISM’s manufacturing and services job indexes both came in below the key 50 threshold that separates expansion from contraction. As SMBC Nikko Securities Americas economist Troy Ludtka notes, this means both the manufacturing and services sectors expect to shrink employment. 

“These two stars do not align often, but when they do it tends to coincide with recession and private job losses,” Ludtka says, adding that in 80% of past instances where the employment components of both the ISM manufacturing and ISM services reports printed below 50, private jobs fell. Both series have registered below 50 in three of the past four months.  

There are labor indicators beyond ISM metrics running contrary to nonfarm payrolls. Ludtka points to a steady decline in private-sector job openings in the Job Openings and Labor Turnover Survey (JOLTS), a steep and steady drop in the number of temporary workers, and recession territory for manufacturing overtime hours. 

The latest data from outplacement firm Challenger, Gray & Christmas showed the number of jobs U.S. employers announced in the first quarter dropped 48% from a year earlier, the lowest number of announced hiring plans since 2016. Announced job cuts meanwhile rose 7% in March from a month earlier. Economists at Pantheon Macroeconomics note that the Challenger layoff announcements lead initial jobless claims by three to six months.  

Then there is the relentless decline in full-time employment, says David Rosenberg of Rosenberg Research. The point is an important one as many strategists debate the recent surge in part-time employment. It is oversimplifying to say that a rise in part-timers is bad. In March, the jump in part-time work was driven by those who said they were working part time by choice, not because they couldn’t find part-time work. 

But it is also incorrect to dismiss the rise in part-time labor because it was driven by those choosing to do so. Michael Green, chief strategist at Simplify Asset Management, says the patterns of part-time work for economic reasons (unable to find full-time work) versus part-time work for non-economic reasons “looks exactly like unemployment, which is why many of us monitor these (now rising) relationships.” 

There are plenty of indications that the labor market isn’t as strong as nonfarm payrolls suggest. To gauge how likely the Fed is to embark on rate cuts in the face of strong headline jobs numbers, investors should watch for officials to highlight lesser-discussed and more accommodating labor-market measures. Officials say they are data dependent, but they get to pick the data.  

Why Fed Easing May Come Sooner Than Markets Think (March 24, 2024)

A deliberately dovish Powell suggests debt-servicing costs, bank solvency concerns and economic cracks outweigh renewed and still-elevated inflation

By Lisa Beilfuss

Federal Reserve Chairman Jerome Powell’s March press conference was decidedly dovish. Yet markets may still be underestimating the central bank’s easy-money bias.

In his post-policy meeting remarks and Q&A session with reporters, Powell downplayed the renewed rise in inflation this year, signaled a tapering of balance-sheet runoff would start much earlier than markets expected, and described financial conditions as restrictive. That is despite signs the inflation upswing isn’t simply seasonal and evidence financial conditions aren’t actually tight, with stocks at all-time highs and crypto “meme coins” quickly minting millionaires. What is more, the messaging came after hot January and February inflation numbers had already led Wall Street to embrace a higher-for-longer policy scenario.

“Powell had all the possibility in the world to simply repeat the slightly hawkish stance of the FOMC press release. He actively chose not to,” says newsletter writer and former hedge fund manager, Florian Kronawitter. 

The dovish messaging wasn’t an accident. Powell tipped off investors on two counts. First, the inflation target is now something above 2%, with Powell saying eight times during his press conference that a return to 2% will happen “over time.” 

Second, the Fed’s asymmetric dual mandate means it won’t take much weakness to spur policy easing, and signs are already present for those interested in looking. That point may seem to conflict with both rising inflation and the Fed’s own updated economic forecasts. But cracks are present not just alongside but because of renewed pricing pressure. Consider the latest small-business survey from the National Federation of Independent Business. Inflation returned as the single most important problem reported by respondents, while small-business owners said they plan to hire at the lowest level since May 2020.  

As for the Fed’s revised economic projections, it raised GDP estimates through 2026. But higher growth estimates effectively lower the bar for the Fed to ease more than the expected three rate cuts this year. It is also possible that such forecasts reflect Fed expectations for more fiscal spending, in the face of economic distress or otherwise. 

Powell’s deliberately dovish messaging shouldn’t be fully ascribed to election-year politics. Bigger picture, though, government debt-servicing costs are a practical constraint. Federal interest payments rose to $1.03 trillion in the fourth quarter, up 24% from a year earlier and up 82% from the end of 2020, before massive pandemic spending and Fed rate hikes. That represents a record 3.8% of U.S. GDP. It is more than the U.S. spent on Medicaid in fiscal 2023, and it is close to surpassing the $1.13 trillion spent on national defense and veterans over the same time frame. 

If Washington is unlikely to aggressively cut spending or raise taxes, interest rates must fall or debt-servicing costs will eat away at discretionary spending–the very business of politicians.

That isn’t to mention hundreds of billions of dollars in unrealized losses on banks’ balance sheets due to the rapid rise in rates. Kansas City Fed researchers said in an October report that the situation has many banks close to insolvent. They essentially concluded that the banking system needs an economic slowdown insofar as lower interest rates are necessary to boost securities valuations. 

A Fed that wants an offramp may already have more cover than many strategists appreciate. Consider recent news out of California’s nonpartisan Legislative Analyst’s Office, citing data from the Bureau of Labor Statistics. The state added only 50,000 jobs last year, down an extraordinary 85% from initial reports. Here are two reasons this matters: California represents 12% of the civilian workforce in the U.S., and the massive revision underlines the trend in downward revisions to monthly nationwide nonfarm payrolls numbers. 

The Philadelphia Fed has separately suggested national payroll growth is much lower than originally reported by the Labor Department, where low and falling survey response rates are one reason monthly data have been plagued with big downward revisions. The Philadelphia Fed’s work to reconcile state-level data suggests a downward revision of at least 800,000 jobs for the 2023 fiscal year ended in September. 

“This suggests that the Fed is skeptical of the mainstream media's narrative that the private sector is robust, a signal that seems to have been overlooked by Wall Street,” says James Thorne, chief market strategist at Wellington-Altus.  

It is probably no coincidence, then, that in his latest appearance Powell four times mentioned “unexpected” intermeeting events or labor market weakness could spur earlier rate cuts. Bloomberg economist Anna Wong described such comments as “strange,” and she notes that the low 4% Fed estimate for unemployment this year means it is “quite easy” to get “unexpected” conditions.

There is an additional, if counterintuitive, reason to bet on a more dovish-than-expected Fed. A February paper authored by a team of economists including former Treasury Secretary Larry Summers set out to square seemingly robust economic data with depressed consumer sentiment. The paper notes the cost of money is no longer included in traditional price indexes, creating a gap between the measures favored by economists and the effective costs borne by consumers.

The economists present alternative CPI measures that reflect mortgage interest payments, lease prices for vehicles, and personal interest payments for car loans and other non-housing consumption. When interest paid is considered as a cost borne by consumers and included in the CPI–as was the case before the index’s 1983 redesign–inflation had a much higher peak and continues to rise at a high level. The authors say their alternative measure suggests headline CPI peaked at an 18% annual rate in November 2022 and still stood at about 9% in November 2023, triple the CPI’s rate. 

One interpretation: Debt-servicing isn’t just an issue for the government, and relatively high interest rates themselves are pushing up household inflation.

Many analysts predict the Fed won’t ease until summer 2024 or beyond–unless something “breaks,” the vague expectation that it will take severe financial-market or economic turmoil to trigger early and swift rate cuts. But it may not take so much trouble this time. Unsustainable debt-servicing costs and losses in banks’ bond portfolios, in combination with weakness in secondary economic data, mean it is possible investors are underestimating the central bank’s dovish disposition and willingness to ease. 

How Shadow Inflation Will Haunt Investors (March 5, 2024)

For signs of mismeasured inflation, look to services, labor and crypto

By Lisa Beilfuss

An in-line inflation report last week prompted a collective sigh of relief across Wall Street. That may be short sighted. 

In January, personal consumption expenditures rose 0.3% from a month earlier and 2.4% from a year earlier. The PCE excluding food and energy, the Federal Reserve’s favored inflation metric, increased 0.4% month-over-month and 2.8% year-over-year. Hot consumer price and producer price indexes for January, plus signs of renewed inflation in recent manufacturing, services and small-business data, had investors on edge about an upside PCE surprise.  

A PCE overshoot, at least with respect to the headline figures, didn’t materialize. But investors’ skepticism might be more appropriate than relief. Looking under the surface, investors should consider what the PCE is missing and think about second-order effects of understated inflation.  

Post-pandemic, misgivings over economic data have become mainstream. But there is a difference between, say, the impact of dwindling response rates on the nonfarm payrolls report and inflation mismeasurement.

In particular, shelter and healthcare costs are mismeasured, says Vincent Deluard, director of global macro at the StoneX. He lays it out this way. To those who have declared inflation dead, inflation is the CPI (or PCE) and what gets measured is what matters. But what doesn’t get measured–such as the homes young people can no longer afford and soaring health insurance premiums–also matter.

Deluard illustrates this idea in terms of the CPI. But the logic and data are relevant for broad inflation analysis. ​​The Daily Treasury Statement shows that healthcare expenses are growing much faster than the medical care services price index, which is showing 0% inflation and still below its June 2022 peak. That is as spending by the Veteran Affairs department and Medicare Part A soared by 15% and 18%, respectively, last year. 

The cost of health insurance, meanwhile, is measured by insurers’ retained earnings, or premiums minus benefits spending. Retained earnings are down 23% year-over-year. Contrast that with data from the Kaiser Family Foundation, which show average annual premiums for employer-sponsored family health insurance coverage rose 7% in 2023 from 2022, and are on track to rise even faster in 2024. 

Deluard suggests the retained-earnings method is silly, but he says fixing the data wouldn’t matter; healthcare is one of consumers’ biggest expenses, but healthcare and health insurance are just 6% and 0.6% of the CPI, respectively. That isn’t to mention that the PCE, where healthcare has a heavier weighting, is indexed to the rate of inflation in Medicaid rates–which are negotiated by the government and have been inflating at a much lower rate than private care.

Mismeasurement amounts to shadow inflation that inevitably finds its way into the labor market, materializing as sticky wage growth, persistent service inflation and uncontained deficits, Deluard says. 

“Someone is paying for actual health expenses, which account for 17% of GDP growth at 7% per annum. Someone is paying (more) to convince workers to abandon mortgages locked in at 3% and pay inflated rents to move for a new job,” he says. Consider the premium for job switchers has jumped to 6% from 4% before Covid, and the costs of wage-intensive services have reset to a plateau of 5-6% for three years. 

It is unlikely, then, that the renewed rise in so-called supercore inflation is a blip. Fed Chairman Jerome Powell since late 2022 has placed particular emphasis on a cut of price indexes that exclude food, energy and housing. Because supercore captures the labor-intensive services sector, it is especially sensitive to nominal wage increases. 

Supercore PCE, representing about half of the total index, rose 0.6% month-over-month in January, the biggest increase since December 2021. From a year earlier, the gauge ticked up to a 3.5% pace. On a 3-month annualized basis, it rose 4.1%--more than double the Fed’s target. 

Economists at the Boston Fed found last summer that the prices of services associated with low-skill workers have driven supercore inflation. They wrote that services have a particularly low frequency of price change, with prices remaining the same for about 15 months on average. Now consider recent survey data from the National Federation of Independent Business, which show a rising share of firms plan to raise prices in coming months. 

It is worth going a step further, beyond the impact of mismeasured inflation on labor. The global crypto market cap stands at roughly $2.52 trillion, according to price-tracking website CoinMarketCap. While that is off a November 2021 high of $2.92 trillion, it is up about 150% from September. That is as daily trading volume across cryptocurrencies has recently picked up to match late-2020 levels. For context, the overall crypto market cap was about $200 billion before the government increased the money supply by 43% in response to the Covid pandemic. M2 money supply is still 36% above December 2019 levels. 

As Bitcoin recently touched all-time highs, 18 new crypto coins with a combined market cap of $26 billion have become tradeable in the past 12 hours (as of writing) alone. What is going on in the crypto market helps make the case that financial conditions aren’t restrictive. But there is a bigger message. The crypto market isn’t just reflecting excess money, but effectively printing more. Crypto is part of the shadow-inflation story, which itself is the (nominal) U.S. growth story.

As one crypto trader put it, about $1.5 trillion in new crypto wealth has been created in the last 15 months. That is equivalent to roughly a quarter of the $6 trillion in Covid-related fiscal spending.

“You literally can’t afford a house unless you YOLO,” another trader said, adding that a renewed crypto boom can be much bigger than the last because of how embedded inflation expectations have become. “You can make 200k a year and not afford a home. People feel the need to take risk, and they are.”

The Fed’s favored inflation gauge, not to mention the CPI, will fall back to target before it should. Aside from reducing longer-term economic efficiency, Deluard warns that “the ghost of shadow inflation” feeds populism, social instability, and geopolitical tension. As such, he suggests investors hedge with long-term TIPS and inflation swaps, plus “chaos assets,” or USD cash. gold, and energy.

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Note that Praxis is off next week and look forward to publishing the week of March 17.

Expectations for Less Government Spending This Year Are Probably Wrong (February 24, 2024)

Economic cracks and rising federal interest expense are two reasons to bet on more fiscal spending and Fed intervention, not less 

By Lisa Beilfuss

The so-called fiscal impulse–whether government fiscal policy decisions are adding to or subtracting from demand in the economy–is broadly assumed to be negative this year. That might not wind up to be true.

A set of announcements in the latest week highlight ongoing government interventions that amount to new stimulus. The Biden administration wiped an additional $1.2 billion in student debt, bringing the sum to about $138 billion. At the same time, the Federal Housing Administration unveiled a new program for delinquent borrowers with FHA-insured mortgages that can temporarily reduce a monthly payment by up to 25%. The agency meanwhile extended pandemic-era aid programs, which were on track to expire in October 2024, though April 2025. 

The latest fiscal efforts, however, shouldn’t be fully ascribed to election-year politics, where the opposing party is a natural counterforce. Consider data from real-estate data provider ATTOM, which show that U.S. properties with foreclosure filings in January rose 5% from a year ago and 10% from the prior month. The point is Wall Street’s broad expectation for fiscal spending to decline in 2024 from 2023 may reflect an underappreciation of weakness under the surface and the government’s desire and ability to support the U.S. economy. 

While no one doubts fiscal spending will remain relatively high for the foreseeable future, it is the change that matters for GDP math. The U.S. deficit roughly doubled in 2023 to 6.2% of GDP, marking the biggest non-recessionary deficit on record. While the full extent of that expansion isn’t considered stimulus in a classic sense, it is clear the federal government took in a lot less cash than it sent out, says Ginger Chambless, head of research at J.P. Morgan’s commercial banking unit. She expects the deficit to remain high relative to GDP, but estimates a narrowing to 5.9%. 

The swing in fiscal spending in 2023 as compared to 2022 boosted inflation-adjusted GDP by 3 percentage points in last year, representing nearly all of 2023’s growth, notes Piper Sandler chief global economist Nancy Lazar.  She expects a fiscal drag of 0.7 percentage point this year, but she warns that risks are to the upside. 

If the tax-cut proposal advanced by Senator Ron Wyden and Representative Jason Smith should become law, and payouts from the pandemic Employment Retention Credit program occur, Lazar estimates a combined $256 billion in fiscal support from those two programs alone. That would add nearly a full point to this year’s GDP, potentially enough to stave off recession, and save roughly 1.5 million jobs to cap this cycle’s unemployment rate at 4.5%. 

All of this isn’t to mention the basic but crucial idea that relatively tight monetary policy itself is exacerbating loose fiscal policy. 

With federal debt now 120% of GDP, Fed rate hikes increase the federal interest expense–and thus overall fiscal deficit–at a faster rate than it slows bank lending and corporate bond issuance, says Lyn Alden, founder of Lyn Alden Investment Strategy. The Congressional Budget Office earlier this month said the U.S. government is on track to spend a larger share of economic output on annual interest payments than at any other point in history.

“The Fed’s control loop is less effective in high public-debt environments than it is in low public-debt environments, and beyond a certain point can even be counter-effective,” Alden says. “Their tools don’t address the fiscal side, and in some cases they can even contribute to a federal debt interest spiral, where more debt needs to be issued to fund larger interest expense, which in turn further increases the interest expense and requires more debt issuance.” Interest earners can meanwhile spend that income into the economy, while large deficits threaten Treasury-market liquidity to potentially force Fed intervention, she adds.

It is worth taking a step back. Several years ago, David Rosenberg, economist and founder of Rosenberg Research, told this writer that a debt jubilee in the U.S.--large scale debt forgiveness–is inevitable. Praxis caught up with Rosenberg over the last week. His thoughts throw cold water on Wall Street’s expectation of a negative fiscal impulse.

Here is how Rosenberg lays it out. The U.S. had a year of full employment, and yet the fiscal deficit grew about 25%. Normally when nominal GDP growth is running at about 6%, like in 2023, the government gets an 8% tax-revenue stream out of it and the deficit dramatically falls. But tax revenue dropped 7% last year. 

“How could the deficit balloon like that with sub-4% unemployment and 6% nominal growth? It’s because of the subsidies. Subsidies layered on subsidies,” says Rosenberg, referencing the CHIPS Act and the Inflation Reduction Act as examples. Illustrating his point: Huge sums from the government have produced a boom in construction spending while industrial production has held basically flat. 

What this amounts to is “jubilee light,” Rosenberg says, started during the pandemic and different from a full jubilee in that there isn’t direct debt monetization. Instead, massive fiscal spending has been financed through the secondary market as the Treasury sells debt into the private market and the Fed buys bonds off of banks’ balance sheets. 

“So much tape and glue has been put on this house of straw that it’s hard to imagine the economy without all this support,” says Rosenberg, adding that economists and investors have no idea what financial assets would look like if the the fiscal deficit and the Fed’s balance sheet ever normalized to pre-2009 levels. 

It may not matter. “The Fed has laid its cards on the table. It doesn't matter if you're on the left or the right,” says Rosenberg, describing how a bloated central bank balance sheet has in 15 years gone from a controversial policy tool to simply part of the landscape. While the current focus is on higher-for-longer interest rates, the bigger picture is that quantitative easing will remain increasingly more aggressive. 

“If they went so far as the high-yield market, maybe they’ll be buying up office space,” Rosenberg says, referring to the Fed in 2020 expanding its emergency bond buying to junk bonds and referencing brewing trouble in the commercial real estate market.

Depending on how one looks at it, expectations for a negative fiscal impulse this year may be overly optimistic. A positive surprise may be the difference between GDP numbers that reflect ongoing growth and numbers that suggest recession. It may also make it increasingly clear that the reality under the surface is precarious, with the U.S. economy requiring evermore support. 

Forget Fed Minutes. Watch New Zealand Next Week (February 20, 2024)

New Zealand’s Central Bank could resume rate hikes next week. What New Zealand does will give context to how the Fed may respond to renewed inflation concerns in the U.S.

By Lisa Beilfuss

How realistic is a scenario where the Federal Reserve lifts interest rates again before cutting them? An inconspicuous clue may come next week.  

Higher-than-expected January consumer prices, producer prices and import prices have traders all but abandoning expectations that the Fed will begin slashing rates in March, with bets now pushed out to a summer start. What is more, the data are stirring discussion around the possibility of renewed tightening this cycle as inflation shows signs of reemerging. 

One month of data isn’t much and economists warn of seasonal distortions. But the January inflation figures don’t seem to be anomalies. Home prices are rising and energy is rebounding. Nominal annual wage growth is settling around 5%. Lending standards are improving, M2 money supply is up 2% since bottoming in October and M2 velocity–how fast money moves through the economy–has risen for nine straight quarters.

As Citi economists Andrew Hollenhorst and Veronica Clark put it, “the U.S. economy has entered a new regime where inflation is more elevated and more volatile.” 

Former Treasury Secretary Larry Summers goes a step farther. In the wake of the latest inflation data, he said there is “a meaningful chance” that the Fed’s next move is going to be upwards in rates, not downwards. While renewed tightening seems to be virtually no one’s current base-case scenario, it is a tail risk worth considering. Summers, for his part, puts odds at 15%. 

As for the base-case: The recent bout of rising inflation data and headline strength in the job market will change the timing and number of cuts–but not the direction of monetary policy–says Joseph Wang, CIO of Monetary Macro. 

Wang notes that Fed officials have articulated a framework that views policy through the lens of real, or inflation-adjusted, interest rates and a neutral rate that is little changed from the pre-pandemic period. Such a framework requires rate cuts in line with declines in inflation expectations to avoid overtightening, Wang says. He concludes that the Fed’s reaction function still points towards cuts, with an inflation upturn translating to fewer cuts than anticipated by markets broadly.  

Minutes from the Fed’s January 31 meeting, due out Wednesday afternoon, may shed light on how officials were thinking about the timing and number of rate cuts before the latest inflation data–helpful if the upturn winds up a blip. But for hints about an outside risk of renewed hikes in the U.S., investors should look to New Zealand next week.  

New Zealand’s Central Bank, the Reserve Bank of New Zealand, has a history of leading other central banks. The RBNZ was the first to hike and the first to pause this cycle, leading the U.S. Fed, notes Jim Bianco of Bianco Research. Going back much farther, the RBNZ created the 2% inflation target that many global central banks eventually adopted.

“They are a forward-looking central bank consistently doing things before everyone else,” Bianco says.

Earlier this month, ANZ Bank New Zealand chief economist Sharon Zollner issued a research report predicting that the RBNZ would hike its main policy rate by 25 basis points in both February and April, taking it to 6%. She acknowledges it is a call that sounds “bananas,” but her logic is instructive for U.S. investors. 

“No one piece of data is to blame but a series of small, unwelcome surprises,” says Zollner. “We just don’t think the RBNZ will feel confident they’ve done enough to meet their inflation mandate.” 

There are of course big differences between the U.S. and New Zealand. One is that the country’s GDP is roughly equivalent to the state of Utah’s. Another is that the current policy rate in New Zealand is still well off its peak rate of 8.5% heading into the Great Financial Crisis. In the U.S., rates then topped out at 5.25%. Yet another: New Zealand isn’t heading into an election, unlike the U.S. where policy this year may not escape politics. 

Still, Zollner’s call is based on conditions in New Zealand that should sound familiar to U.S. investors. Among the surprises she lists: higher-than-expected CPI; a lower-than-expected unemployment rate; higher-than-expected net migration; sticky high-frequency price intentions; and immense fiscal stimulus. At the same time, so-called green shoots are emerging precisely because of a widespread expectation that rates have peaked.

She lays out the two-sided risks facing the central bank. Hike, and the worst-case scenario is that the lagged impacts of previous tightening are just about to bite. Don’t hike, and the worst-case scenario is that inflation is actually really quite embedded. As Zollner sees it, there is no way to avoid exacerbating one risk or the other. Ultimately, though, the latter worst-case scenario would be much more painful than the former.

Zollner makes the point that the central bank probably wouldn’t restart the hiking cycle for the sake of 25 basis points. The upshot she lays out is worth considering given the booming stock market and tight credit spreads in the U.S., indications that financial conditions aren’t very restrictive. 

“The shock value of restarting hiking and re-establishing uncertainty about how high rates might go could have a chilling impact on the housing market and investment beyond what ’50 basis points’ would normally mean,” she says. “That wouldn’t necessarily mean more hiking wasn’t needed. It could just mean it was really effective, and did its job unusually fast.”

A rate hike next week in New Zealand doesn’t mean the Fed will quickly follow suit. Nonetheless, how New Zealand responds to  stubborn inflation may give U.S. investors a read on how the Fed will proceed in the near term. It seems fair to assume the Fed has a bias toward cutting, given the new asymmetrical average inflation-targeting framework that tolerates above-target inflation more than rising unemployment and because of an emphasis on real rates. But a pivot by the RBNZ will draw attention to the tail risk of more Fed hikes. At the very least, a hawkish surprise in New Zealand may throw even more cold water on current Fed cut expectations.

A Second Wave of Inflation is Already Underway (February 12, 2024)

Plus, Harley Bassman on how to bet on higher-for-longer interest rates

By Lisa Beilfuss

Upside inflation risks are reemerging, complicating monetary policy in a way many investors may not yet appreciate.

There has been a broad assumption that inflation will continue to descend from current levels–3.9% and 2.9%, annually and respectively, for the core consumer price and personal consumption expenditure indexes. But there is building evidence that such an assumption is flawed. Should inflation rise anew, economic data may reflect rising prices precisely when investors expect the Fed to begin cutting interest rates, creating headwinds for markets and the Fed alike.

Consider details of the Federal Reserve’s latest SLOOS, or senior loan officer opinion survey on bank lending. The consensus takeaway that bank lending remains tight isn’t wrong. But the details suggest the trend is shifting as bank lending in the latest quarter became significantly less tight versus recent quarters. Jim Reid of Deutsche Bank highlights credit standards for commercial and industrial loans, which tightened at their slowest pace in seven quarters. Lending standards for C&I loans to small firms leads GDP by two quarters, Reid says, noting that the latest data “represents a significant moderation of what had been the very negative SLOOS signal.”

What is more, credit standards lead wage growth by six-to-nine months, says Andreas Steno Larson, CEO of Steno Research. While loan demand is still “underwhelming,” he says credit demand lags credit supply and financial conditions by a quarter and predicts a rebound in loan demand during the second quarter.

“The SLOOS reveals that the U.S. economy is accelerating and that inflation risks are back,” Steno Larson says. “Inflation is likely going to return with a vengeance. If the Fed cuts in May, they will end up cutting straight into a cyclical upswing.”

Now consider what is happening in the background. A housing recovery has already started, says Apollo chief economist Torsten Sløk, as falling mortgage rates meet pent-up demand and low inventory. The S&P CoreLogic Case-Shiller Home Price Index has risen on a year-over-year basis in each of the past five months (the latest data are for November). It last rose 5.4% from a year earlier, the biggest year-over-year increase since November 2022. Housing comprises about 40% of the CPI and 25% of the PCE, with shelter inflation in those baskets lagging home-price changes by about a year.

Already, the three-month annualized core CPI has moved higher three months in a row. That metric bottomed in September at 2.96% and rose to 3.32% in December. Fed Chairman Jerome Powell emphasizes the so-called supercore CPI, which excludes shelter in addition to food and energy. It bottomed in October, rising from 3.70% then to 3.91% in December.

Regardless of whether energy prices are excluded from an inflation metric, such prices affect virtually all goods and services. The renewed CPI rise has been without energy prices contributing. But so far this month, crude oil has gained 5.7% while Brent crude has gained 5.4%. A breakout in energy prices here would not only underpin headline inflation momentum, but potentially push inflation expectations higher. Stable inflation expectations are crucial because price expectations influence behavior and can amount to a self-fulfilling prophecy.

“Expect to see inflation expectations starting to creep higher in upcoming surveys,” says DeLuc Trading’s Craig Shapiro, a development that could undermine the current narrative that the Fed is about to embark on normalization cuts because falling inflation means real, or inflation-adjusted rates, are more restrictive.

Praxis in the past week spoke with famed bond investor Harley Bassman, also known as the Convexity Maven. He says the bond market hasn’t been so disconnected from Fed policy in over 30 years. Bassman, for his part, believes inflation will remain elevated for longer than many investors think, and he sees just three rate cuts this year that don’t begin until July. Markets are pricing in 53% odds that the Fed cuts rates at least five times this year starting in May.

“We’re not there yet,” Bassman says about inflation figures. Moreover, he says, an unemployment rate still below 4% and a 3.4% GDP estimate from the Atlanta Fed’s GDPNow model aren’t numbers associated with falling inflation.

That is not to mention Powell’s potential concerns about his own legacy. “He does not want to be Arthur Burns,” says Bassman, referring to the former Fed chairman from 1970-78 blamed for cutting rates too soon and rekindling inflation. “Paul Volcker is thought of as a saint and Burns as then-President Richard Nixon’s lap dog. Powell wants to be remembered like Volcker,” Bassman says, referring to the Fed chair who followed Burns and choked inflation.

Bassman offers one way to bet on a higher-for-longer policy outcome: Buy newly issued, higher coupon mortgage bonds.

Mortgage-backed Securities (MBS) are the second largest bond asset class after U.S. Treasuries, and they are implicitly backed by the U.S. government because of government-sponsored entities like Fannie Mae. Historically, newly issued MBS yield roughly 75 basis points over 10-year U.S.Treasuries, and presently the spread is nearly double that amount.

Now managing partner at Simplify Asset Management, Bassman has created an exchange-traded fund for non-professional investors to directly own only newly issued MBS which currently yield about 5.75%. For more on the strategy, you can read more from Bassman here.

A higher-for-longer policy outcome assumes a familiar reaction function, where the Fed responds to above-target inflation with tighter policy. It is unclear whether and how factors including a new average inflation targeting framework, $2 trillion in global debt maturities this year, and a looming election will influence policy decisions. Regardless, investors should prepare for a renewed pickup in inflation that may become more evident in the coming months.

Parsing Powell: What the Chairman Said, and Didn’t Say, on 60 Minutes (February 5, 2024)

The Fed Chairman may have dropped some unintended and overlooked policy hints

By Lisa Beilfuss

This week’s article was going to focus on the January jobs report. Until Fed Chairman Jerome Powell’s 60 Minutes interview aired Sunday night.  

While this writer isn’t sure what the 60 Minutes segment was intended to accomplish, it may give investors reason to doubt that the central bank manages monetary policy and the economy quite as the consensus assumes. This week we have prepared a synopsis of noteworthy excerpts from the interview, followed by our own commentary, that may help investors read between the lines of official Fed speak and economic forecasts. 

The excerpts, in bold, are from the CBS transcript of Powell’s interview with Scott Pelley.

“I can't overstate how important it is to restore price stability, by which I mean inflation is low and predictable and people don't have to think about it in their daily lives. In their daily economic lives, inflation is just not something that you talk about. That's where we were for 20 years. We want to get back to that, and I think we are on a path to that.”

In the 20 years leading up to the Covid-19 pandemic, the total consumer price index averaged a 2.17% year-over-year increase. If inflation was already averaging at the Fed’s 2% goal for two decades, then why did Powell announce in August 2020 a new average inflation-targeting framework that allowed for inflation to run hot, ostensibly to offset periods of sub-2% inflation? In this context, his comments suggest the true inflation target is simply the highest rate possible before agitating the public.  

“The broader situation is that the economy is strong, the labor market is strong, and inflation is coming down. And my colleagues and I are trying to pick the right point at which to begin to dial back our restrictive policy stance. That time is coming. We've said that we want to be more confident that inflation is moving down to 2%. And I would say that I think it's not likely that this committee will reach that level of confidence in time for the March meeting, which is in seven weeks.”

Nonfarm payrolls have been strong. But it probably shouldn’t be the go-to job-market indicator: The response rate is low and falling, it is no longer a coincident indicator but a lagging one, and it double counts multiple job holders. Alternative measures are sending a weaker message. 

Consider a finding from economist Courtney Shupert at MacroPolicy Perspectives. She has been analyzing fourth-quarter earnings calls for hiring/firing actions, and says layoffs are exceeding hiring for the first time since 2020. 

Now go back to the Fed’s new inflation framework. Since the goal is to average 2% over some unspecified period of time, it means that the central bank’s dual mandate (full employment and price stability) is asymmetrical. The point is that the Fed will probably respond quickly to labor market weakness even if inflation is above target. Such weakness could be evident to the Fed by March, even if a “level of confidence” about 2% inflation isn’t.

“We do not consider politics in our decisions. We never do. And we never will. And I think the record -- fortunately, the historical record really backs that up….If we tried to incorporate a whole 'nother set of factors in politics into those decisions, it could only lead to worse economic outcomes.”

Powell’s response to a question about politics potentially affecting changes in monetary policy is a textbook answer. But it may be incomplete. Recall President Joe Biden took more time than expected to renominate Powell as Fed chair. That announcement came on November 22, 2021. Eight days later, and after nearly a year of arguing that price inflation was transitory, Powell said it was time to abandon the word “transitory” in describing inflation. 

“Headline inflation, which is total inflation including, you know, energy and food prices, that's our target. But we look at core inflation, which excludes energy and food prices because that tends to be a better indication of where things are going.

It is unclear if Powell’s reference to headline inflation as the Fed’s target was an error or a Freudian slip. But it is worth considering it alongside the latest personal consumption expenditure index. The core PCE, which is the Fed’s stated target and the metric used in its quarterly Summary of Economic Projections, most recently rose 2.9% from a year earlier. The total PCE last rose 2.6%. 

Policymakers say they are data dependent. But the reality is that they emphasize the data that fit the decisions they want to make. Total PCE is currently a friendlier series for a Fed wishing to ease sooner than later. 

“I don't think [a real-estate led banking crisis is] likely. We have work-from-home, and you have weakness in office real estate, and also downtown retail. There will be losses in that. We looked at the larger banks' balance sheets, and it appears to be a manageable problem. There's some smaller and regional banks that have concentrated exposures in these areas that are challenged…We're working with them to make sure that they have the resources and a plan to work their way through the expected losses.” 

Powell’s comments around the commercial real estate problem come as the Fed’s emergency Bank Term Funding Program (BTFP) is set to expire in March. The Fed is meanwhile prodding all banks to tap its discount window at least once a year to try to remove the stigma of borrowing from the facility. But unlike the BTFP, where collateral has been valued at par, banks using the discount window must provide collateral valued at market prices subject to a haircut based on the quality of the collateral pledged. 

The Fed Chair may be relatively unfazed because he expects to cut rates soon. But that is probably naive. 

Consider what one distressed real-estate investor recently told Bloomberg: “The percentage of loans that banks have so far been reported as delinquent are a drop in the bucket compared to the defaults that will occur throughout 2024 and 2025,” said David Aviram of Maverick Real Estate Partners. “Banks remain exposed to these significant risks, and the potential decline in interest rates in the next year won’t solve bank problems.”

“We're making changes steadily in supervision to make it more effective. And we're actually working on proposals now on the regulatory side. You know, we want to get this right. We want to learn the right lessons and get it right. And so, we're working on those proposals on the regulatory side. And I think we'll be coming out with things this year for consideration. When we do a rule, we send it out for comment. And then we read those comments, and we try to try to come to a good place.”

Powell’s comments about Fed changes after the March failure of Silicon Valley Bank, the second largest U.S. bank failure, don’t convey urgency. That is despite renewed regional bank concerns that have taken the SPDR S&P Regional Banking ETF (ticker: KRE) down 10% this month.  

It is unclear whether Powell is unduly optimistic, steeped in bureaucracy, or simply sees some bank failures as a necessary part of the cycle. Regardless, his comments lend credence to some analysts’ view that a wave of bank failures is inevitable and will spur interest-rate cuts, an abrupt end to balance-sheet runoff (QT), and a potentially quick return to quantitative easing (QE).  

Consider a September 2023 paper by University of Southern California professor Erica Jiang and others. It found that 10% of U.S. banks have larger unrecognized losses and lower capital than SVB, which prompted the creation of the BTFP program last March. What is more, the researchers found that even if only half of uninsured depositors decided to withdraw, roughly 190 banks with total assets of $300 billion are at a potential risk of insolvency–meaning that the mark-to-market value of their remaining assets would be insufficient to repay all insured deposits. 

Now consider that the Federal Deposit Insurance Corporation’s (FDIC) Deposit Insurance Fund (DIF) balance was $117.0 billion as of June 30, 2023, an amount that would strain the FDIC (and the government) should several regional banks fail. 

The End Is in Sight for Quantitative Tightening (January 30, 2024)

Lower Treasury borrowing estimates have dashed QT wind-down hopes. But it probably won’t matter. 

By Lisa Beilfuss

A lower-than-expected borrowing estimate from the U.S. Treasury has pushed out expectations for when the Federal Reserve will taper and complete its balance-sheet shrinkage. But the connection may not be as straightforward as many assume, meaning investors may be in for a positive surprise.

The Treasury on Monday said it plans to borrow $760 billion in the first quarter, lower than its $815 billion estimate last fall and down from $776 billion in the fourth quarter of 2023. For the second quarter, Treasury estimates $202 billion in issuance, down from $278 in last year’s second quarter. (Second-quarter borrowing is usually lower because that is when individual income tax returns are due).  

As Bleakley Capital’s Peter Boockvar notes, Treasury’s quarterly refunding announcement is now market-moving news because of enormous debts and deficits. But there is another reason for increased Treasury refunding attention: Many strategists say less borrowing translates to a longer stretch of quantitative tightening (QT), or the reversal of pandemic-era bond purchases known as quantitative easing (QE). 

The connection between Treasury borrowing and QT is mostly discussed via the Fed’s overnight reverse repurchase facility, or RRP. The central bank uses the RRP to provide a floor on the rates at which money market funds, primary dealers and banks are willing to lend to counterparties. After a period of relatively stable balances during the first half of 2023, the RRP has quickly dropped to roughly $600 billion from over $2.2 trillion in December 2022. 

The RRP decline is a function of Treasury borrowing and is thus partly by design. When the Treasury issued $1.6 trillion in net bills last year, it pushed money market rates above the RRP offering rate, prompting money market funds out of the RRP and into Treasuries.

At the current rate of rundown, the RRP will be near zero by June, estimates Joe LaVorgna, chief economist at SMBC Nikko Securities. Some predict sooner. 

Market participants view the level of funds invested in the RRP as an indication of banking-system stress, where a bigger balance suggests less stress. LaVorgna explains it this way: Because the RRP is a liability on the Fed’s balance sheet, bank reserves are created when the RRP declines. That adds liquidity to the financial system, negating QT and lifting risk assets. And so once the RRP bottoms, the negative effects from QT resurface as its effects are more pronounced in financial markets. 

Some officials have expressed concern about the fast drop in the RRP. “In my view, we should slow the pace of runoff as overnight RRP balances approach a low level,” Dallas Fed President Lori Logan said in a recent speech, adding that doing so could reduce the likelihood the Fed would have to stop QT prematurely. 

While connecting the RRP level to the end of QT makes sense, the consensus analysis may be too simple. In other words, relatively lower Treasury issuance and a related slowdown in the RRP decline likely won’t preclude the Fed from winding down QT and finishing its balance-sheet shrinkage sooner than later. 

First, consider this point from Craig Shapiro, macro advisor at LaDuc Trading. The Treasury often gets its initial borrowing estimates wrong, so there was little risk for Treasury Secretary Janet Yellen to announce a low borrowing number for the second quarter. “They were wildly wrong last year. She can always issue more bills if necessary later in the quarter if they are light on revenue,” Shapiro says.  

Early data support Shapiro’s point. Overall federal tax deposits are up just 0.1% this month from a year earlier and have slowed to 5.6% fiscal year-over-year, down from a 7.8% pace at the end of December, notes Richard Farr, chief market strategist at Merion Capital. Moreover, income and employment withholdings taxes in January are down 0.8% fiscal year-over-year.

Second, markets may be misinterpreting the RRP and missing the bigger picture as it relates to Fed policy. Steven Ricchiuto, U.S. chief economist at Mizuho Securities, says he isn’t convinced that a diminishing level of RRP reflects increased stress in the financial system. 

Instead, he says the RRP level reflects investor preferences for investing cash balances. Ricchiuto emphasizes bank reserves (note that the RRP yields roughly 5.3% and bank reserves earn about 10 basis points more), which must be large enough relative to the level of economic activity in order to support bank lending. Right now bank reserves are about 15% of bank assets and 12.5% of GDP, well off highs of 19.5% and 17.5%, respectively, he says. What is more, both metrics have declined to levels seen in 2018-2019–when troubles in money markets forced the Fed to abruptly end QT.  

“Our longstanding call for the Fed to begin tapering QT early this year reflects our calculation that the maximum the balance sheet can be trimmed is $2 trillion, given the expansion in the economy in the wake of the fiscal stimulus still being provided,” says Ricchiuto. His estimate is within sight. The balance sheet currently stands at $7.68 trillion, down from a peak of $9 trillion and compared with about $4 trillion leading up to the pandemic.  

For all the focus on the liquidity minutiae, there is a third point that is as salient as it is simple. “The Fed doesnt know how QT works,” says Joseph Wang, a former Fed trader and CIO at Monetary Macro. “We could have the Treasury market become disorderly. That could make the Fed change its plans.” All of this is not to mention the fact that a soft landing, or the perception of one, is at stake and an election is approaching. 

For investors, QT was always the more interesting side of the Fed’s tightening campaign, even if Fed officials and news media have focused almost exclusively on interest rates. Less QT tends to be good for risk assets. The notion of data dependence is illusory; if the government wants to curtail QT, it will do so.   

Navigating Geopolitical Risks: A Conversation With Marko Papic (January 21, 2024)

“The risk is in the politicization of monetary policy. Nobody wants to talk about it, and nobody is really positioned for a really aggressive Fed in 2024.”

By Lisa Beilfuss

Surveys across Wall Street suggest investors see geopolitics as the biggest risk in 2024. But if risk is about unexpected outcomes, how should investors think about geopolitics if that is where so much attention is already focused?

In the latest week, Praxis spoke at length with Marko Papic, chief strategist at alternative investment management firm Clocktower Group. Papic leads Clocktower’s strategy team, covering geopolitics, macroeconomics and markets. Previously, he founded BCA Research’s geopolitical strategy practice, the financial industry’s first dedicated political analysis investment strategy. He is also the author of the book Geopolitical Alpha: An Investment Framework for Predicting the Future.

An edited version of the conversation follows.

Praxis
There is a lot going on geopolitically. Where are the biggest risks for investors this year?

Marko Papic
Let’s start with how to think about risk. For investors, it’s about something unexpected happening. Geopolitical risk lies where investors aren’t looking. 

With that said, too many investors and geopolitical analysts have overstated the probability of a regional war in the Middle East. There is some chance that the Israel-Hamas war spirals, but there’s a reason it hasn’t already. It may still expand into Lebanon, but the main players–Saudi Arabia and Iran–don’t want war.  A lot of the violence is occurring in non-macro relevant parts of the Middle East, like Houthis lobbing missiles at commercial ships in the Red Sea, and that's not going to have any real investment implications other than for shipping companies.

The Ukraine-Russia conflict is in stasis and it's increasingly becoming a frozen conflict. If anything, it offers only upside surprises in terms of performance of some European assets. The Taiwanese election that just ended was very positive in terms of the outcome, and also in terms of how China has reacted to that outcome. 

So where is the risk? Right now, investors aren’t yet taking the U.S. presidential election seriously. More specifically, the risk is in the politicization of monetary policy. Nobody wants to talk about it, and nobody is really positioned for a really aggressive Fed in 2024.

You’re saying the biggest geopolitical risk for investors is the 2024 presidential election here at home?
By far. My bias has always been to downplay the outcome of an election. But this time around, assuming Donald Trump is the Republican nominee, I don't think that investors understand how much the American establishment sees Trump as a threat. This bit is misunderstood and it matters because I think investors underestimate just how much the Fed's reaction function could be influenced by politics in this election. 

What I'm telling you is a story that's almost fantastical. It's like Lord of the Rings as far as most investors are concerned. It's like I'm describing Turkey, not America. That's where I think the risk is, that disconnect between the expectation of what is the relationship between politicians and the central bank in the U.S. and the reality that I think we're actually in.

Why do you think the Fed might be influenced by politics this cycle?
First, think back to December. There is no data that warranted the pivot in December, other than the core PCE was coming down. But that was the case for months. So why did they choose December to pivot? You cannot explain that to me unless there's an unobserved variable that's motivating them to be lenient, which I think is politics. It's the threat of a Donald Trump presidency.

Second, it is just reality. Most investors, particularly in the U.S., find it uncouth to suggest that the Fed is political. It's not something you speak of in polite society because most investors in the U.S. have been raised on this mythology of an independent Fed.

I don't subscribe to that mythology. I think the Fed is a political institution. And when you have an anti-establishment candidate running for president with a clear intention of attacking that establishment–he plans to fire tens of thousands of federal employees–of course the Fed is not going to ignore that.

What about the economy? Can politics really eclipse economics when it comes to monetary policy, or are you saying it is all related?
If you think about what the Fed really cares about, it's anchoring long-term inflation expectations. I can tell you that the price of gasoline or the price of food and rent don’t matter. The policy decisions–politics–are what matter for long-term inflation expectations.

In that way, a Fed concerned about inflation expectations should lean against Trump. I don't use the word “should” normatively because I don't care who wins. I'm a nihilist. But I am saying the Fed is going to get involved and I think that that's just something that ideologically and normatively most American investors just don't want to contemplate.

So regardless of the economic data, the Fed is cutting soon and aggressively?
For the last year and a half, the median investor has convinced themselves that Powell wants to be Paul Volcker, not Arthur Burns, and is serious about 2% inflation. 

If we get a growth slowdown and sticky inflation, the median investor is like, ‘well, they're going to focus on inflation. They cannot cut in that scenario.’ And I am saying, no, they're going to cut like crazy. They don't care. 

Inflation could go back up to 5%, and they wouldn't care. Oil prices could quadruple because of war in the Middle East and they'll say, "Look, it's geopolitics, it's transitory, it's not something that the Fed really focuses on." The narrative will shift dramatically.

How much easing do you see?
Think about different scenarios. If there is a recession, how many cuts would the market expect? If there is no recession, how many cuts would the market expect? I want to bet more cuts than the market expects in any scenario. 

What if growth accelerates further? I don’t think that will happen this year, and so I am no longer maniacally bullish as I was for the past 18 months. But let's imagine a scenario where growth does reaccelerate. What would the Fed do then? I would say that they will not hike for sure. There's almost no scenario in which the Fed will hike. 

Can all of this be true at once? Can’t economic conditions alone merit easing?
The Fed will target employment much more aggressively than inflation for at least the next 12 months. If we do actually get a recession, I think it's highly unlikely that we get one that is severe. 

But I think the Fed’s reaction to even a shallow recession will be quite dramatic. There's this emerging consensus that in the next recession, the Fed will not cut rates as much and they won’t do QE. That's absolutely bonkers. If we have a recession, they'll cut by more than 300 basis points. They'll do QE, they'll do whatever they have to stabilize growth because a recession ahead of the election will definitely produce a populist outcome that they want to avoid.

When was the last time US politics were the top geopolitical risk for markets?                   
I can't think of a case where U.S. politics was a risk to investors. Most U.S. elections have not mattered. As an investor, did you care if Bob Dole or Bill Clinton won in the mid-'90s? In 2016, Trump was a faux populist. He said all sorts of stuff that made people lose their minds, but in terms of his policies, he was actually a pretty centrist run-of-the-mill establishment Republican. He cut taxes–how anti-establishment!

This time I think Trump is a European-style anti-establishment figure. Last time, Trump put a bunch of Goldman Sachs executives in the White House. But many people who came from the establishment and worked for him have since either testified against him, written a book, or gone on cable TV to say mean things about him. It is not clear to anyone that Trump would pick the same kind of a cabinet and advisers this time around. 

Are there other election-related risks for investors apart from Fed policy?
Let's say three, four months from now, Biden continues to poll as poorly as he is polling now. Democratic presidents facing re-election and difficult polling have a history of being aggressive on foreign policy. 

Biden doesn't really have domestic legislative initiative anymore because the Republicans are controlling the House. But in terms of foreign policy, a U.S. President doesn't have many constraints. We already saw that with the Houthis and the attack in Yemen. Maybe that isn’t enough. Maybe there needs to be a fight picked with China. I don't mean a major one, but maybe more export rules, maybe more rules on investing in China–the kind of foreign policy that can impact markets.

How do the interplays you describe–politics, economics, Fed and fiscal policy–net out for investors?
I think it's very difficult to be very bearish on equities throughout 2024 because I think the Fed will have an itchy trigger finger due to politics. The Fed has 525 basis points to cut. That’s a lot of ammunition. That is the first reason why I think U.S. stocks should at worst be flat on the year, but quite possibly could actually go up quite a bit.

The dollar should suffer in a world where the Fed is lenient and behind the inflation curve. In that case, global equities should outperform the U.S. 

As for bonds, I think they could rally as investors get surprised yet again by being wrong on growth. In 2023, bonds had one of the worst sell-offs in history because everyone was wrong about a recession. And now you could have everyone wrong that we’ve landed softly. Bonds might do a round trip if I'm right about the Fed cutting rates, because that would reignite consumers. The economy could actually be on fire by the end of the year.

Fed Easing Is Coming, Regardless of the Data (January 15, 2024)

A “constitutionally dovish” central bank using the core PCE risks locking in higher inflation  

By Lisa Beilfuss

Prevailing questions across financial markets–whether the Federal Reserve will ease soon and aggressively–miss the forest for the trees. The better question: How much of a mistake will such policy easing turn out to be?

U.S. central bankers say they are data dependent, giving markets the impression that monetary policy is effectively technical. But data often send conflicting messages. A dual mandate of price stability and maximum employment requires trade offs, and politics inevitably seep in. In reality, the Fed shifts its data emphasis to fit preordained policy decisions. 

The Fed in 2020 adopted a flexible average inflation-targeting regime, which it used to justify a delayed response to rampant inflation. Fed Chair Jerome Powell has backed out housing on top of food and energy to come up with what he calls “supercore inflation.”  

So-called core measures of inflation–silly because households and businesses can’t exclude food and energy–were introduced in 1975, no coincidence given the sources of high inflation during that era. Treasury Secretary Janet Yellen, during her tenure as Fed chair, focused on alternative measures of employment than the unemployment rate to justify loose policy. 

“They cherry pick the data to do what they want to do and change to justify the policy they want to take,” says Stephen Miran, fellow at the Manhattan Institute and former senior advisor at the Treasury Department. “Markets think the Fed has a constitutionally dovish bias, and I don't see reasons to think the market is wrong.”

Miran gives several reasons for such bias. First, inflation was subdued for a long time and so there is muscle memory of being complacent. Second, many of the dominant personalities at the Fed have been ideological doves. Chairs aim for consensus, and Miran notes it has been decades since a Fed governor dissented. Third, politics are inescapable when chairs and governors are appointed by presidents and confirmed by the Senate. 

“This is a Fed that has managed to work climate risk into bank regulations. It is hard to believe it’s a Fed that isn’t political,” says Miran. 

All of this creates a backdrop investors might consider alongside a widening gap between two major inflation indicators. The wedge between the core PCE and core CPI suggests forthcoming easing may reignite pricing pressures that are already hotter than central bankers acknowledge. 

Since 2000, the Fed has targeted the core PCE, or the personal consumption expenditures index excluding food and energy. The index is on track to fall to the lowest rate since prices began to run in the spring of 2021. Economists at Deutsche Bank predict a 2.9% year-over-year rate for December, down from 3.2% in November.

Before 2000, the Fed relied on the core CPI, or the consumer price index excluding food and energy. That is one reason the public, including the media, still focuses on the CPI over the PCE. The CPI unexpectedly rose in December, increasing 0.3% month-over-month and pushing the year-over-year rate to 3.4% from 3.1% in November. Core CPI rose 3.9% last month versus 4% in November. 

Core CPI has long run hotter than core PCE, but the difference has been much smaller. St. Louis Fed data show that in the five years leading up to the onset of the pandemic, the gap averaged four-tenths of a percentage point. Going back 20 years, the gap averaged three-tenths of a percentage point. Now, it is a full point.

There are two main factors behind the current wedge. Thinking through them should leave investors skeptical of the notion that inflation has been defeated–and that even the significantly hotter CPI is capturing real-world inflation.

First, the PCE weighs healthcare more heavily than the CPI. What is more, the PCE includes expenditures made on behalf of consumers. This means it uses Medicare and Medicaid reimbursement rates set by the government, pulling in artificially low prices that may not reflect what consumers are actually spending. 

Miran puts the problem this way. When people think about inflation, they probably don’t consider Medicare reimbursements to hospitals and instead consider what they experience–from food and gas to haircuts and hotels. If underlying inflation is closer to where CPI is running, declaring victory based on the PCE risks entrenching higher underlying inflation in the economy. Undue attention on costs not experienced by consumers–what the PCE measures by design–thus means the Fed will create more inflation in prices directly experienced by consumers, Miran says.

This isn’t to say that swapping the CPI, which counts expenditures made directly by consumers, is an perfect fix. Here is one example of its own flaws. The CPI calculates health insurance costs based on lagged insurer profitability, and the index showed a 27% decline in the category last year. Yet insurance giant UnitedHealth Group (ticker: UNH) reported a 5.6% increase in revenue per member for 2023. At least in this category, CPI is also understating real-world inflation.

Housing is the second reason for the inflation-gauge gap. The CPI weighs housing more heavily than the PCE, with shelter accounting for about 40% of the core index. Some strategists have downplayed relatively high CPI readings based on consensus expectations for rent deflation, but the notion is faulty. 

Enduring Investments founder Michael Ashton says the private data behind falling-rent assumptions are low quality. Costs never improved for landlords and keep getting worse, all while a mismatch remains between available housing stock and where people are moving, he says. Ashton warns that rent inflation will outpace expectations and is more likely to speed up than slow down. 

An updated forecast from real-estate marketplace Zillow (ticker: Z) underlines Ashton’s point. The company now expects U.S. home prices to rise 3.5% this year, up from an earlier forecast of flat prices. The price of shelter as measured by the CPI tends to follow home prices by about a year.

The debate over whether the Fed will ease soon and more than officials say misses the bigger point. The core PCE will easily allow the central bank to justify dovish policy, supporting certain asset classes, such as commodities, in the near term. It may also entrench higher inflation and give way to a new wave.

Alternative Labor-Market Data Are Sending A Message Investors Should Heed (January 8, 2024)

Employment measures from the ISM and NFIB suggest the job market isn’t so solid–and Fed expectations may be too sanguine

By Lisa Beilfuss

The latest employment situation report from the Labor Department has bolstered soft-landing expectations. But investors relying on it for economic and monetary policy signals may be caught off guard. 

In the wake of the December jobs report, Treasury Secretary Janet Yellen tried to confirm what much of Wall Street has been betting. “What we're seeing now I think we can describe as a soft landing,” Yellen said on CNN Friday. But any such landing will likely be a layover.

First, a reminder about why investors should remain skeptical about jobs-report headlines and cursory analysis based on them. The figures that get the most air time, the nonfarm payrolls change and the unemployment rate, were solid at 216,000 and steady at 3.7%, respectively. But the details belie the headlines. Here are a few.

Some 676,000 people left the labor force last month, the most since January 2021, putting artificial pressure on the unemployment rate. Full-time employment fell by 1.5 million, the fourth biggest drop on record going back to 1968. Temporary hiring, one of the few leading indicators in the monthly jobs report, fell for the eleventh straight month. Ten of the past 12 nonfarm payrolls numbers have been revised lower, to the tune of 472,000–a level Piper Sandler chief economist Nancy Lazar says is typical of recessions. 

That is not to mention government hiring, which accounted for 24% of all hiring in December. It wasn’t an anomaly. Total government payrolls last month broke the record previously set in mid-2010, and government hiring represented a full quarter of overall hiring in 2023. 

There are alternative data sources to the Labor Department’s employment situation report. At least three privately compiled metrics are sending a message investors should heed.

Consider the employment component of the Institute for Supply Management’s Services PMI. It dropped 7.4 points from November to 43.3–the weakest since August 2009 and well into contraction territory (50 is expansion-contraction threshold in such diffusion indexes). 

In the history of the ISM Services employment index, which goes back to 1997, there are only three periods with a bigger plunge, says Arch Capital Group global chief economist Parker Ross. Those periods include November 2008, which marked the worst monthly job losses of the 2007-2008 financial crisis; March and April 2020, when parts of the economy were shut down; and February 2014, when severe winter weather hurt job growth. 

One month isn’t a trend. But even if you take the three-month moving average, the jobs metric in the ISM Services report fell to the lowest level since April 2010, notes Joe LaVorgna, chief economist at SMBC Nikko Securities. 

Ross makes another observation. Before Covid, private services employment within the nonfarm payrolls report and the jobs metric within the ISM Services report used to be closely linked. But since 2021, there's been effectively no correlation between the two measures, he says. 

One explanation could be the precipitous fall in businesses’ response rate to the BLS establishment survey, which produces the nonfarm payrolls number. The response rate fell to 42% from 60% pre-pandemic, suggesting that there is increased guesswork in compiling the data and arguing for added emphasis on the ISM’s measure.

The employment component of the ISM Manufacturing survey meanwhile contracted for the third straight month in December. “These two stars do not align often,” says Troy Ludtka, economist at SMBC Nikko Securities, referring to the employment gauges in both the ISM’s Services and Manufacturing reports. He adds that in 80% of past instances where both series printed below 50, private jobs fell. In 62% of instances, the economy was in recession.

The story isn’t just in ISM data. The National Federation of Independent Businesses said in its latest report that a net 16% of small-business respondents plan to create new jobs in the next three months. While the number is still positive, it fell two points from November, it has halved from its record high in August 2021, and it reflects the lowest share since 2017.

The low-and-falling BLS establishment survey response rate aside, it may be that the ISM and NFIB data are simply leading the government’s nonfarm payrolls report. Lazar says that on average, it has taken 23 months after interest-rate liftoff for the jobless rate to rise. That 23-month mark will be hit in February. Contrary to conventional wisdom, then, it isn’t taking longer than normal for Fed tightening to boost unemployment.

One upshot of emphasizing the private ISM and NFIB employment numbers over the government’s employment report: Investors who do so should have an alternative Federal Reserve policy map. Nonfarm payrolls still topping 200,000 (before revisions) and a sub-4% unemployment rate neatly fit the soft-landing narrative and square with the Fed’s estimates for three interest-rate cuts and a drift to 4.1% unemployment this year. 

But the signals from ISM and NFIB support bets that the Fed will cut much more aggressively this year. To wager otherwise is to believe the labor-market slowdown won’t continue. Lazar asks the obvious question: “But why? Because Fed funds have likely peaked?” 

That answer is too simple–just as the analysis underlying the soft-landing narrative is some combination of incomplete, premature and naive. Using inputs including corporate profits and bank lending data, Lazar’s model for cyclical (business-cycle sensitive)-employment predicts a sharp contraction in employment this year. 

As economist at recession forecaster Arturo Estrella notes, the Fed since 1989 has paused its rate-hiking campaign just before the recession would later be known to have started (the last hike was in July). The Fed always cuts rates sharply during the recession itself, Estrella says.

Estrella’s basic but salient point taken alongside alternative labor-market indicators means that bets for six rate cuts this year may wind up looking benign.